Early Retirement Options with Pension Plans and IRAs
So, you want to bail out of the rat race early? Good for you. But, what are your options with your pension plans and IRA’s. Fortunately, with a little advanced planning you can avoid those gruesome premature tax penalties usually inflicted on early withdrawals. In general terms, an early withdrawal is any withdrawal before age 59 ½. The penalty is a flat 10% of the amount withdrawn.
Miscellaneous and Hardship Exemptions
First, there are exceptions to the penalty tax for early withdrawal due to death, disability, and first time home purchase, medical expense, unemployed person’s medical insurance, and higher education expense. Except for the disability exception, which has a very strict definition, these exemptions usually don’t fit the needs of an early retiree for meaningful amounts of steady income.
Life annuity payout
If your qualified pension plan payout is in the form of a life annuity, it doesn’t matter how old you are, you won’t be subject to the penalty tax. But, many profit sharing, 401(k), or defined contribution pension plans may not offer an annuity payout as a termination benefit. Even if they do, annuity payments may not offer the flexibility and benefits available with an IRA rollover.
Separation from service after age 55
If you were between age 55 and 59 ½ when you separated from your employer, you may qualify for a little known exemption. Your qualified pension plan could make payments to you in any amounts you desire without penalty. (This won’t work with IRA’s and you won’t qualify if you were under age 55 when you terminated even if you leave your account in the plan until you reach 55.)
Annuity Schedule Payments
Perhaps the most useful exemption for many early retirees are offered for IRA’s under what is often referred to as “Section 72(t)” arrangements. You may calculate payments under three different methods that offer lots of flexibility to meet your needs. But, beware. Once you begin a series of payments, you are committed until the later of: age 59 ½ or five years of distributions. So, if you begin the program at age 58, you must continue until age 63. And if you begin at age 42, you must continue withdrawals until age 59 ½. Any variation from your selected schedule will result in penalties on all previously withdrawn funds and interest! If you have been in the program for a number of years, this penalty and interest could be a truly crushing blow. As you can see, Section 72(t) doesn’t meet the needs of those seeking a one time, variable, or occasional payment from their IRA’s.
Calculations are reasonably straightforward, at least by IRS standards!
A. Life expectancy method: Divide your life expectancy (or your joint life expectancy with your beneficiary) as found in the IRS tables into the account balance as of the previous December 31 each year. This method will lead to a variable payment that may be quite trivial in early years for young people. Assuming positive investment experience, the payments should grow over time.
B. Amortization Method: Again using either your own or your joint life expectancy, calculate a payout using both principal and “reasonable” interest rates over your projected life expectancy. This calculation is exactly like a home mortgage, and will result in level payments that will be larger than under payment method A. The “reasonable” interest rate is not exactly defined, but there is a private letter ruling that accepts the “120% Annual Long-Term Applicable Federal Rate” as reasonable. These rates are published monthly. The reasonable rate determines the maximum allowable withdrawals under the plan, but smaller withdrawals are allowed.
C. Annuity Factor Method: This method allows for the use of a shorter life expectancy assumption found in the IRS UP-1984 tables. This shorter life expectancy leads to somewhat higher withdrawal amounts than the amortization method above.
Use caution with high fixed withdrawals under method B or C above. You may experience capital depletion if your investment experience is not at least as much as the withdrawal. Watching your funds depleted at an early age will not make you feel good, and there is no provision for reducing payments due to poor investment performance. Remember those penalties we talked about earlier?
After you have either attained age 59 ½ or been in the program for 5 years, which ever is later, you are free to vary the withdrawals any way you wish until you reach the mandatory withdrawal point at age 70 ½.
One final point that adds some flexibility for your planning. You do not have to consider all of your IRA’s when doing the calculations. You could split up your IRA into more than one and do the Section 72(t) calculation and withdrawals from any one you like. That opens up the possibility of either starting a second 72(t) payment series later if you need more than you first thought, or drawing on the remaining IRA’s after age 59 ½ but before you reach the end of the five year period if you started after age 54 ½.
Even if you are the kind of person who would rather undergo a root canal without Novocain than prepare a budget, you still are going to need a good idea of what your income needs are and how you are going to meet them. After you add up all your sources of income, such
as Social Security, rent, royalties, military and corporate pensions, and the like, the difference between that predictable income and the amount of money you are going to need during your retirement is the amount that must be generated by your savings and investments. You may or may not find it helpful to track every dollar coming in and going out, but you need to have a good handle on what your income and expenses actually are—and are likely to be.
But how much money will you need? Here is a quick rule of thumb that you need to keep uppermost in your mind during retirement: For every $1 of annual income you need to generate from your savings, you should have at least $25 in your capital account. That’s what it takes to have a sustainable withdrawal rate of 4% from a diversified portfolio that should last at least 30 years. If you withdraw more than 4% a year, you significantly raise the probability that you will run out of money at some point. If withdrawal rates were stop lights, 0–4% would be green, 5% would be yellow, and anything above 5% would be red.
If you haven’t done so already, you ought to consolidate your retirement capital accounts in one institution that can provide a single statement. This will allow you to tell at a glance how you are doing financially, and it will also greatly simplify management and distributions, lower costs, and in general save time and aggravation. It’s hard to keep everything straight when you spread out your affairs over multiple accounts, brokerage houses, and banks.
You can roll all your old 401(k), 403(b), profit sharing accounts, and lump sum pension distribution accounts into a single IRA for ease of administration. However, you will need separate accounts for your Roth IRA, Roth 401(k), or 403(b) accounts.
Avoiding 10% Penalty
Early Retirement: Avoiding the 10% Penalty
So you want to retire early? Good for you. But, even if you have enough total funds to comfortably support yourself, some retirement plan assets may be locked away or awkward to access.
By now, almost everyone is aware of the 10% penalty imposed on early withdrawals from qualified retirement plans. These are imposed subject to a few exceptions (death, disability, education expense, first time home purchase, etc.) on any distribution prior to age 59 ½.
To avoid the penalty, try to live off your personal accounts until at least past the age 59 ½ early retirement penalty tax period. This maximizes deferral, avoids potential tax penalties for early retirement, and provides the greatest flexibility.
However, if you don’t have sufficient personal assets to provide for your income needs until age 59 ½, and you don’t qualify for one of the exceptions, all is not lost. There are three provisions you should know about:
1. If you have money in a 401(k) or other qualified retirement plan, and you employer permits it, you may be able withdraw assets without penalty if you separated from service after age 55. This might be a great source of funds if you retire between 55 and 59 ½. Note: Not all qualified plans allow this. It’s depends on the plan document. This distribution option is not available to IRA’s.
2. If you have employer stock at a low basis inside your retirement plan, there is a little known provision that may be very valuable to you. You may withdraw your employer stock from the plan paying tax only on your basis. If you sell the stock immediately the profit is subject to capital gains rates. However, if you hold the stock, any further appreciation after distribution will be taxed at ordinary income tax rates until held for an additional year.
This provision may allow you to transfer a significant value out of your plan at very favorable tax rates. By systematically liquidating your company stock over the number of years until age 59 ½ you may be able to support yourself at very low total tax cost.
Keep in mind that this special provision for company stock must be part of a total distribution from the plan, and you may not pick and choose shares at other than the average cost basis of the stock. The balance of the distribution may be rolled over into an IRA just like any other total distribution. However, if you roll over the stock into an IRA, the option is lost.
3. Finally, if you have not reached age 59 ½ you still can tap into your retirement plan assets under a plan of “substantially equal distributions over your projected lifetime” under an IRS regulation commonly referred to as Section 72(t). You will be required to continue your distributions until the later of age 59 ½ or five years. Any deviations will subject you to 10% penalties on all previous distributions. So, it’s definitely not flexible.
The regulations give us three ways to calculate allowable withdrawals. Between them you can design almost any reasonable schedule of distributions. Starting from the smallest distributions they are:
a. Divide your life expectancy or the joint life expectancy of you and your beneficiary into the balance of your account on December 31 of the previous year. (Some observers believe that this method may not be available after 2001 because the new distribution regulations do not specifically mention this table. We await further comment from the IRS.)
b. Amortize your account over your life expectancy or your joint life expectancy with your beneficiary using a “reasonable” interest rate.
c. Use an annuity factor derived from the IRS tables for your life expectancy or the joint life expectancy of you and your beneficiary.
If your calculated distribution is more than you think you will need, you can split your IRA into smaller accounts that give you the distribution you want. Later, if you need to, you can begin another distribution from another IRA. But each separate distribution will start the clock running for its own five-year period.
If you have enough capital to retire, the various tax and pension regulations will not provide much of an obstacle. With just a little advanced planning, you will soon be sailing off into the sunset. Call us to explore your options.
Wherever you end up with your accounts, make sure each one has the appropriate beneficiary designations, or Pay on Death (POD) arrangements. It’s particularly important that you get this right, because retirement accounts carry tax-planning challenges (and opportunities) with them. You can arrange for your heirs to receive a lifetime of tax-deferral benefits from your accounts, or create a tax disaster by making the wrong choices. We can’t overemphasize the importance of getting professional advice here.
Lots of other things are changing in your life at retirement time. This might be a very appropriate occasion to make sure that your wills, trusts, powers of attorney, durable powers, instructions to health care professionals, living wills, and insurance and retirement beneficiary designations are all up to date and reflect your current desires. Again, get professional legal, accounting, and financial planning advice.
Health Insurance, Medicare, and Long-Term Care Insurance
There is no bigger threat to a happy secure retirement than health care costs. If you are too young for Medicare, don’t leave your job without a reliable health insurance option in place. You can extend your insurance with COBRA coverage for 18 months after leaving employment. After that, you will need some other arrangement.
If you are eligible for Medicare, study the options and make the best choice you can from the existing hodgepodge of plans. (Now that you are going to have a bit more free time, let your elected representatives know that we need to fix the health care system in a very fundamental way. With somewhere around 50 million uninsured Americans, even those with “good” insurance at risk for catastrophic medical bills, you would think we could do better.)
If you and your spouse are nearing your retirement you may be able to maximize your retirement benefits by electing and suspending as well as using the spousal benefit.
If you are the higher income earner than your spouse and current cash flow is not a big issue. You can elect and suspend your social security at full retirement age (usually 66 for people around this time). This allows for your benefits to accrue until your 70 at which time you can take a larger monthly payment.
Your spouse can take half of the retirement benefit you would have had at 66. Your spouse can then delay their SS until 70 letting it accrue as well.
One pitfall to be careful of though is the spouse electing their benefit before their full age of retirement (66). If they do this, they won’t be able to switch over to their own increased benefit at age 70 (assuming it has grown to be largest of the two). The spouse will be stuck with the 1/2 spousal benefit