Ready to Retire Early? Here are Your Options
Most Americans think that age 60 is the proper age to collect retirement benefits. The truth is you must be at least age 62 years old to collect Social Security benefits (at a discounted rate). But, you can make penalty free withdrawals from your qualified retirement plan(s). And, U.S. military reserve and National Guard members are also eligible for early retirement pay.If you receive a distribution from a qualified retirement plan (401 plan; 403(a) annuity; 403(b) tax sheltered annuity; IRA; or IRA annuity) prior to reaching age 59 1/2 you will be subject to a 10 percent early withdrawal penalty on the taxable portion of the distribution. The 10 percent penalty is in addition to any federal and state income tax due on the distribution. There is no tax on the portion of the distribution that is a return of previously taxed employee contributions or of nondeductible IRA contributions.
Exception to the 10 Percent Penalty:
You can avoid the early withdrawal penalty and receive distributions prior to age 59 — by utilizing Internal Revenue Code (IRC) 72(t). IRC 72(t) provides that qualified retirement plan distributions will not be subject to the early withdrawal penalty if they are made as part of a series of substantially equal periodic payments (no less than annually) for the life (or life expectancy) of the individual or the joint lives (or joint life expectancies) of the individual and his or her designated beneficiary.
However, 72(t)(4) states that if the series of payments, that is otherwise excepted from the 10 percent early withdrawal penalty, is subsequently modified (other than by reason of death or disability) within a five-year period beginning on the date of the first payment, or, if later, age 59, the exception will no longer apply. Under these circumstances, your tax for the year of modification will be increased.
Account Withdrawal Methods:
IRC 72(t) (2) provides three methods for calculating how much can be withdrawn penalty-free from a retirement plan. The methods are the required minimum distribution method, fixed amortization method, and the fixed annuitization method.
Required Minimum Distribution Method (RMD). RMD consists of an annual payment determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. Under this method, the account balance, number from the chosen life expectancy table and resulting annual payments are recalculated annually.
Fixed AmortizationMethod. The annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years determined using the chosen life expectancy table and the chosen interest rate. Under this method, the account balance, the number from the chosen life expectancy table and the resulting annual payment are determined once for the first distribution year and the annual payment is the same amount in each succeeding year.
Fixed Annuitization Method. The annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer's age and continuing for the life of the taxpayer (or the joint lives of the individual and beneficiary). The annuity factor is derived from the mortality table and the chosen interest rate. Under this method, the account balance, annuity factor, chosen interest rate and the resulting annual payment are determined once for the first distribution year and the annual payment is the same amount in each succeeding year.
Life Expectancy Table:If a single life expectancy table is utilized for the required annual distributions it must be utilized in all subsequent distribution years. Alternatively, if the joint life and last survivor table is utilized, the account survivor must be the actual beneficiary of the account owner. If there is more than one beneficiary, the identity and age of the beneficiary used for purposes of each of the methods is determined under the rules for determining the designated beneficiary for purposes of 401(a)(9). The beneficiary is determined for a year as of January 1 of the year while the interest rate that may be used is any interest rate that is not more than 120 percent of the federal mid-term rate (determined in accordance with 1274(d) for either of the two months immediately preceding the month in which the distribution begins).
One Time Conversion or Early Termination:
IRS Revenue Ruling 2002-62 allows you to may make a one-time penalty free change from one of the two fixed withdrawal methods to the minimum distribution method. However, a subsequent change to the withdrawal method will be treated as a modification under IRC 72(t) (4) and will trigger the 10 percent early withdrawal penalty. Alternatively, if you elect to terminate the series of substantially equal periodic payments the 10 percent early withdrawal penalty will apply to all distributions to date, plus interest from the date of the distribution to the date the individual discontinued the program.
Additional Exceptions to the 10 Percent Penalty:
The following retirement plan early withdrawal scenarios will also be exempt from the 10 percent early withdrawal penalty: (i) distributions made to a beneficiary (or to the estate of individual) on or after the death of the individual; (ii) distributions attributable to disability; (iii) distributions made after separation from service after attainment of age 55 (excluding distributions from IRAs); (iv) distributions from an IRA to an unemployed individual for health insurance premiums; (v) $10,000 "first-time homebuyer" early withdrawal from an IRA; (vi) early withdrawal of IRA funds to pay higher education expenses; and (vii) qualified reservist distributions for individuals called to active duty.