PAYNE FINANCIAL MANAGEMENT, L.L.C.
|
Retiring Prior to Age 59 1/2 = 10% IRS Early Withdrawal Penalty, Right?
|
Probably not. Often when meeting with potential retirees, the question of the Internal Revenue Service’s
10% “early withdrawal penalty” invariably enters our conversation. You know, this is the penalty that the
IRS put in place to deter individuals from raiding their tax-deferred retirement nest eggs prior to reaching
age 59 ½ (IRS Publication 575). Many times these folks ask me about some of the various interesting and
sometimes quite unusual techniques they have heard about to avoid this penalty. I will tell you, I have even
had individuals reveal to me their plans to “temporarily” divorce their spouse so that they can avoid it.
Well, I promise that there are easier ways, and the first question that I ask is simply this, “Will you be 55
years of age in the calendar year that you retire?”.
Although the IRS allows exceptions for such circumstances as: permanent disability; deductible medical
expenses in excess of the 7.5% AGI limitation; divorce under a QDRO payment; dividends received from
an ESOP; and death of the account owner, the majority of individuals retiring prior to attaining the age of 59
½ must seek other methods to avoid this penalty. By far the exception method that I get the most questions
about is commonly referred to as “72(t)”, and refers to IRC §72(t)(2)(A)(iv) and §72(t)(3)(B). These
sections of the Internal Revenue Code allow for an exception to the 10% penalty if distributions are taken
under what is termed as “substantially equal periodic payments”, or SEPP. But beware, this common
technique carries with it several pitfalls that could prove devastating, and its application appears to be
misunderstood by many.
Basically an annuitization of the account balance, the SEPP method typically involves the rolling over
(technically a “Trustee-to-Trustee Direct Transfer”) of an employer sponsored retirement plan to an IRA.
Payments are then determined by using a very specific calculation method that includes factors such as life
expectancy, current AFR interest rates and the present balance of the retirement account. Once the
payment schedule begins, it cannot be materially altered and must continue for at least five years or until
the account owner reaches age 59 ½, whichever is greater.
While in some cases the 72(t) or SEPP exception method may make sense for a retiree (under age 55), I do
not recommend this technique for most individuals as it carries a high level of risk. First, the calculation
must be extremely precise and the payment schedule must be maintained throughout the entire period (no
matter what). Flexibility is therefore absent from this method, and I have yet to see a newly retired client
that knows exactly how much income to the penny that they will need over the first five years. As current
interest rates are very low, the calculated payment will tend to be too small, and if inflation rears its head
there is no remedy. Lastly, if any material alterations to the payment structure do occur, the IRS can deem
the exception method to be broken. If so, not only will the 10% penalty be levied retroactively to when the
distributions began, but applicable interest and penalties for the underpayment will be assessed.
I may have a better alternative. Over the years it continues to surprise me how little is commonly known
about the other 72(t) penalty exception provided in IRC §72(t)(2)(A)(v) and §72(t)(3)(A). Referred to as the
“early retirement provision”, or ERP, these code sections allow for an exception to the penalty provided
that 1) The individual attains a minimum age of 55 by the end the calendar year (12/31) in which they
separated service from their employer, and 2) Distributions exempt from the penalty must be withdrawn
directly from the individual’s employer sponsored defined contribution plan (e.g., 401(k), Profit Sharing
Plan, 403(b), etc.). Please note that distributions from IRAs do not qualify for this exception, and serves as
another good reason to think carefully before automatically rolling over your retirement assets.
The positives inherent with the ERP method are many and tend to run counter to the risks of the SEPP
method. First, the payment amounts maintain complete flexibility, and can be easily adjusted at any time if
desired. This allows individuals to fine tune their income needs for changing expense patterns, or to offset
the impact of inflation over time. Second, one-time or ad hoc distributions can be facilitated as needed to
meet any unforeseen needs. For my clients this issue is extremely important, as it allows them to enter
retirement without any unnecessary constraints on their funds. Lastly, there are no technical calculations to
adhere to, no interest rate issues, or specific payment schedules that if not adhered to exactly might cause
the exception to be disallowed.
As favorable as the ERP exception appears, it does have a couple of drawbacks. The first involves the lack
of adequate investment alternatives in the typical 401(k), 403(b), etc. Although satisfactory during the
accumulation years of your employment, upon retirement it is imperative that a prudent, disciplined and
comprehensive asset allocation strategy be implemented. I have yet to observe an employer sponsored plan
that I feel has adequate investment capabilities for accomplishing long-term post retirement goals. The
second drawback to the ERP approach rests squarely with the lack of responsiveness that most outside
plan administrators provide (or should I say don’t provide). With a considerable number of plan
participants, most large plan administrators are not equipped to deal with the detailed needs of individual
retirees.
Okay, then what is the best overall solution? When working with a retiring client who meets the 55 + years
of age / separation from service requirement, is under the age of 59 ½, and will require retirement income
from their 401(k), Profit Sharing Plan, 403(b), etc., we often implement a dual strategy that allows them to
take full advantage of the ERP exception, while at the same time using the extensive investment
opportunities inherent in an IRA.
How is it accomplished? By temporarily separating the retirement portfolio into two distinct functions, the
employer sponsored plan can be utilized to fulfill the short-term income requirements of the retiree, and an
IRA can be created to initiate the long-term investment process. Please note that although two accounts will
be utilized on an interim basis, they are continuously managed as one aggregate retirement portfolio.
Therefore, the overall asset allocation will be reflected within each account according to the exact purpose
(i.e., short-term cash and fixed income components would be primarily held in the employer sponsored plan).
Establishing appropriate starting balances for the two accounts depends upon the anticipated total of
income payments needed prior to reaching age 59 ½, and a comfortable amount for any unforeseen
potential cash needs. During the first few years, I always encourage clients to leave some extra funds in the
employer sponsored plan as a “safety net”. At certain intervals we review the excess amount, and if
appropriate, move some of the funds into the IRA for investment efficiency.
What are the final results? When the retiree attains the age of 59 ½, the 10% early withdrawal penalty is
no longer an issue and the accounts are reconsolidated typically into the IRA. As withdrawals during the
interim period were derived only from the employer sponsored defined contribution plan, the retirement
income will not be subject to the penalty. Furthermore, each January, the plan’s administrator will send to
you a Form 1099-R that displays a distribution code 2 (early distribution not subject to 10% early
withdrawal penalty), to be used for tax return preparation. Lastly (and maybe most importantly), by this
time the individual’s long-term comprehensive asset allocation strategy should be well established. Thus the
IRA’s value should be sufficient to have covered all previous income distributions, with a favorable inflation
adjusted return for good measure.
06/22/10
Jeffrey C. “Butch” Payne, Jr., CFP®
Payne Financial Management, L.L.C.
210 Interstate North Parkway
Suite 700
Atlanta, GA 30339
(770) 989-7019 Office
(800) 257-0254 Toll Free
(770) 989-2653 Fax
Need help with understanding how this effects your specific situation? Just
give me a call @ 800-257-0254, and I will be glad to answer your questions.