How to tap retirement funds before age 59½
Many people dream of retiring early, but what if they need to tap into retirement funds before reaching the "golden years"? While withdrawing from an IRA should be a last resort, there are ways to access money from a retirement account penalty-free. However, the rules can be tricky, so an investor should do research before making any final moves. Here are three strategies to consider.
Leaving a job at age 55 or older
There’s a little-known tax code exception that allows employees who leave jobs at age 55 or older to take penalty-free withdrawals from 401(k) accounts. The rule applies if you retire, quit, or even get fired.
A few caveats to keep in mind:
- The rule doesn’t apply to funds in an IRA. This means if 401(k) assets are rolled over into an IRA before age 59½, the benefit is lost.
- It also doesn’t apply to funds still held in a previous employer’s 401(k) account. The good news is there’s a workaround to provide early access to those funds: Before leaving a current job, consider whether or not to transfer the assets from any previous 401(k) plans into a current plan.
About withdrawing previous Roth IRA contributions
- An investor can withdraw contributions to a Roth IRA at any time without incurring taxes or penalties, no matter the investor’s age or reason. Any earnings on the principal, though, are subject to penalty if they don’t meet certain exceptions or are distributed before reaching age 59½.
- Withdrawing those Roth IRA contributions may be a useful tool to help bridge the gap between retirement and the date when an investor has penalty-free access to funds in their Traditional IRA or 401(k).
Take substantially equal periodic payments (SEPP)
If an investor is in the position to retire before age 55 and wants penalty-free access to the tax-advantaged funds they’ve invested, IRS rule 72(t) allows IRA and 401(k) account holders to take a series of payments based on life expectancy, as long as certain criteria is met.
In short, distributions must:
- Be substantially equal from year-to-year.
- Continue for at least five years, or until an investor reaches age 59½, whichever comes later.
- Be calculated according to one of the three IRS-approved methods.
Each of the three distribution methods yields a somewhat different withdrawal amount and the IRS allows an investor to change the method only once. That means it’s important to choose carefully. An investor could take out too much and wind up with a nest egg that may not sustain them throughout retirement. Or they could take out too little and find themselves having to supplement income with another job.
Here’s how it works: Assume an investor is 50 years old, has a $1,000,000 portfolio, and opts to calculate based upon a single life expectancy, with an interest rate of 1.55%. According to the E*TRADE 72(t) calculator, the annual distribution amount for each method would return:
- Required minimum distribution (RMD) method: $29,240
- Fixed amortization method: $37,892
- Fixed annuitization method: $37,725
Note that the distribution amounts are shown as annual figures, however, an investor may choose to make withdrawals monthly, quarterly, or semi-annually. Rule 72(t) payments can begin at any time, for any reason. The rule requires the series of substantially equal periodic payments to last for at least five full years OR until the IRA owner reaches age 59½, whichever is longer. For example, if an investor begins taking payments at age 56 on December 1, 2018, the investor may not take a different distribution or alter the payment amount until December 1, 2023, even though the fifth payment was taken on December 1, 2022.
Any changes to the payment amount prior to meeting the required distribution period may result in a 10% penalty tax, plus interest applied retroactively to all previous payment amounts.
As mentioned above, the IRS has approved three acceptable calculation methods to determine the required dollar amount of the series of payments:
1. RMD Method
This is the simplest method and typically results in the lowest required payout amount. The current value of the IRA is divided by a life expectancy factor. This is the only method that is recalculated every year and the payment amount changes annually as the account value changes.
2. Fixed amortization method
The required distribution amount is determined by amortizing the account value over a life expectancy assumption and a reasonable interest rate factor. This calculation sets a fixed dollar amount to be distributed each year.
3. Fixed annuitization method
This method applies an annuity factor and a reasonable interest rate assumption to calculate a fixed annual required distribution amount each year based on life expectancy.
In addition, the IRS requires the interest rate used for 72(t) payments to be less than or equal to 120% of the federal mid-term rate for either of the two months immediately preceding the month in which the distribution begins.
Lastly, there are three different life expectancy tables that the IRS allows an investor to use when calculating a 72(t) withdrawal with the fixed amortization or the RMD methods. It is important to note that once a distribution method and life expectancy table have been chosen, an investor cannot change either throughout the course of distributions, except for a one-time change from the fixed annuitization or amortization methods to the RMD method.
The three life expectancy choices are:
This is a life expectancy table developed by the IRS to simplify minimum distribution requirements. The uniform lifetime table does not use a beneficiary’s age to determine the resulting life expectancy. This table can be used by all account owners regardless of marital status or selected beneficiary; however, it is generally used by an unmarried owner, or an owner whose spouse is not the sole beneficiary, or an owner whose spouse is not more than 10 years younger.
Single life expectancy
This is a life expectancy table that also does not use a beneficiary’s age in the calculation. This table can be used by all account owners regardless of marital status or selected beneficiary. Choosing single life expectancy will produce the highest payment of the three available life expectancy tables.
Joint life expectancy
This is a life expectancy table that uses the account owner’s age and oldest named beneficiary’s age to determine the combined life expectancy. It is generally used by a married owner whose spouse is both more than 10 years younger and the sole beneficiary of the account.
It’s worth noting the equal payment provision under rule 72(t) is extremely complex. If investors or their 401(k) provider’s plan sponsor gets it wrong, the investor could be subject to a tax modification, where the 10% penalty applies retroactively to all previous distributions. That’s why it’s so important to be diligent and conscientious when making this decision, and when considering any other retirement plan distribution strategy. E*TRADE from Morgan Stanley does not provide tax advice, so contact your tax advisor for information specific to your situation.
Visit Retirement Planning to learn more about Traditional and Roth IRAs, and take advantage of our educational tools and resources that can help you understand about how to plan for retirement. You’ve worked hard. You should be able enjoy it. If you have any retirement questions, please call us at 800-387-2331 (800-ETRADE-1) to talk with an E*TRADE representative.