Avoiding Penalties on IRA Withdrawals
Reader Question: “How do I draw money out of my IRA before age 59½ without a penalty?”
Years ago, Congress passed legislation to encourage American workers to save for their own retirements through 401(k)s, 403(b)s, IRAs and similar tax-advantaged accounts. Typically, contributions to these types of accounts can be made on a “pre-tax” basis and any earnings are also shielded from income taxes until they are withdrawn. As part of this “no tax until you take it out deal,” special rules also apply on how and when you can use these funds.
Age 59½ Rule: Unless an exception applies to your particular situation, a 10% additional tax (penalty) will apply to any distributions you take from an IRA (and certain other types of retirement accounts) before you reach age 59½. After age 59½ and before 70½, you may take whatever amount you choose without penalty. After age 70½, certain required minimum distributions (RMDs) must be taken or other penalties may apply.
Age 59½ Exceptions: To avoid punishing someone with a real need to access their retirement money before age 59½, Congress included exceptions for the 10% penalty, such as: you incur large medical expenses (more than 7.5% of your adjusted gross income) and don’t get reimbursed for them; you lose your job, but continue to pay for health insurance covering you, your spouse or your dependents; you become totally and permanently disabled; you die before 59½ and leave your IRA to your estate or to named beneficiaries; you pay for higher education expenses for you, your spouse, your children or your grandchildren; you are a first-time home buyer; you get divorced and have to give some or all of your IRA to your ex-spouse; or you take “substantially equal periodic payments” out of your IRA over your lifetime.
Using the “substantially equal payments” exception is one of the more common techniques to draw on IRA money without triggering a 10% tax penalty, especially when your situation isn’t dire. Three standard methods have been approved by the IRS to calculate “safe” annual withdrawal amounts that won’t trigger the penalty while you are under age 59½ (also referred to as “72(t) distributions,” named after the related tax code section). Let’s assume, for example, you are retiring at age 50 with a $300,000 401(k) and you roll it into an IRA. Under current tax laws and interest rates, you would be permitted to take about $11,000 a year without triggering the 10% tax penalty. Basically, you’ll need to draw this same amount from your IRA until age 59½, or five years, whichever is longer. Failure to comply with the dollar amount or the length of time will trigger tax and interest penalties on all of your withdrawals. In this example, the 72(t) distributions would need to continue for at least 9½ years (the longer of five years or age 59 ½). Thereafter, withdrawals can be discretionary.
Now, let’s change our example by making your early retirement age 58 instead of age 50. The 72(t) distributions would be about $13,260 a year and, as before, they would need to continue for at least five years, or until age 59½, whichever is longer. In this case, you wouldn’t be able to increase the dollar amount of your withdrawals until age 63, even though you are over 59½. Given this inflexibility, it is often better to delay retirement until age 59½, use non-IRA sources of income or look at other options.
Generally, the pre-59½ distribution options outlined above for IRAs also apply to 401(k) and 403(b) accounts. If you retire before age 59½ and the 72(t) distribution amounts are adequate, you could leave the money in your employer’s plan or roll it into an IRA for the same result. However, if you are retiring after age 55, consider leaving your money with your former employer (instead of rolling it to an IRA) because more flexible rules could apply for drawing your retirement income directly from these plans. If you retire at age 55 or older, you can draw any amount from a 401(k) or a 403(b) account without triggering the 10% penalty and without the fuss of the 72(t) distribution calculations or restrictions. The catch is that you must be age 55 or older and maintain your account with your former employer. Rolling your account into an IRA eliminates this more flexible age 55 option; the age 59½ rules would then apply. Withdrawals from a 403(b) or 401(k) plan before age 55 would still be subject to the age 59½ rules and penalties.
Distribution planning can be complex and confusing, so before you withdraw money from your IRA, seek tax and financial advice. A CPA or qualified adviser can help keep your retirement income penalty-free.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.