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. But if you need them to support your life style here’s how to unlock them without penalty.
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 in to 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).
Even if you decide to reenter the work force, 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 per the appropriate IRS table into the balance of your account on December 31 of the previous year. This method required annual recalculation using both your new attained age and previous year’s balance.
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.
As always, plan well and be guided by your qualified tax professional.