Part Two of Four: What’s the best way to avoid the 10% IRS penalty?
Over the years, you’ve been told that if you take money out of your traditional IRA before age 59 1/2, that you’ll be penalized with a 10% early withdrawal penalty.
For the most part, that is true but there is a workaround to the rule.
The way IRA withdrawals work, if you are younger than 59 ½ and you start taking out random distributions out of your IRA, then you’ll be subject to federal, state and the 10% early withdrawal penalty. This could add up to over 35% of your withdraw being taxes and penalties. Not fun.
There are some specific ways to avoid the 10% penalty such as disability, certain qualified educational expenses, first time homebuyers, qualified military personal called to active duty and death.
Let’s talk about the workaround that allows you to avoid the 10% early withdrawal penalty. First of all, you’ll still have to pay the federal and state tax, there is no way around these two. (unless you live in a state with no state taxes.) The workaround is called Rule 72(t)
So what is this Rule 72(t)?
The IRS allows for substantially equal periodic payments that allow you to access your traditional IRA at any age without the 10% penalty. Basically, it allows for you to take an income stream from your IRA which can be setup to pay you monthly, quarterly or annual payments.
Now, you don’t want to just pull a number out of the air to establish your income payment. The IRS has three formulas available that qualify for the 72(t) calculation.
1. The required minimum distribution formula (RMD) (Generally produces the lowest income)
2. The amortization formula
3. The annuity factor formula (Generally produces the highest income)
You’ll also have to pick whether you are running the calculations on single life, joint life or the uniform lifetime table.
The website, bankrate.com, has a nifty 72(t) calculator that you can plug in your numbers to give you an idea of what you may receive. https://www.bankrate.com/calculators/retirement/72-t-distribution-calculator.aspx
There are a few catches to using 72(t)
Once you start the substantially equal periodic payments, you must keep them going for five years or 59 ½ years old, whichever is longer. For example, if you are 53 years old and start taking payments, you’ll have to keep the payments going until you are 59 ½. Once you reach 59 ½, you can then change your payments. If you are 57 and start taking payments, then you’ll need to keep those payments going for five years or 62 years old before you can change it.
If you chose the amortization or annuity factor formula, you have a one-time option to change to the RMD formula once you have the program going.
What if you need to change the payment or take more money out? The bad news is if you make changes in any way to the program, you’ll be on the hook to pay the 10% early withdrawal penalty on that withdrawal you just made. The really bad news is that you have now canceled the 72(t) and you’ll have to pay the 10% retro back to the first dollar you took out under the 72(t) program. Ouch. So be careful but you can do it!
When I was an advisor, I would often times split one IRA into two IRA’s if I was doing a 72(t) for a client. For example, let’ say you have a $300,000 IRA. You need some income from the IRA but you don’t need the maximum that it will provide. You can split the IRA’s into two different IRA’s. Let’s say one will have $200,000 in it and the other one has $100,000. You could setup the 72(t) program on the $200,000 IRA, which will provide you with an income stream. You could have the second IRA not under the 72(t) program and you could use this one for the “just in case I need it” IRA. This would give you income from one IRA and access to the second IRA just in case you need it.
Can you setup a 72(t) income stream from a 401k or 403B plan?
You can if you are no longer employed with the employer. If you still are working and contributing to the plan, then you are not able to.
I would not suggest you try this on your own. Make sure you have a qualified financial advisor or tax consultant assist you with this process. If you need assistance, you can contact me and I’ll put you in contact with an advisor who specializes in helping people retire early. (No, it’s not me. I’m retired.)
This is part 2 of a 4 part series. Stay tuned for part 3 soon!
If you missed it, check out Part one: Accessing your Retirement Funds prior to 59.5 (You can but don’t do it!!)