Using Periodic Payments To Retire Early

By Clifton Linton
Senior Writer,  mPower

The good news: You opened an IRA when they became available in the 1970s. You saved diligently and even rolled a 401(k) or two into it. Now you're 55 with an IRA balance that lets you think about quitting work.

The bad news: Because you're under 59½, the IRA rules don't seem to offer any obvious way to withdraw your money without paying an early withdrawal penalty.

By contrast, 401(k) and 403(b) retirement plans allow you to withdraw money if you are at least 55 when you stop working for the employer sponsoring the plan.

SEPP Strategy

Most of the exceptions, which are found in a part of the IRA regulations called Section 72(t), require you to have some type of hardship. But, you can avoid the penalty if you "annuitize" your withdrawals. That means you create a string of relatively equal annual payments based on your life expectancy. In IRS lingo, you set up a series of substantially equal periodic payments, called a SEPP.

While Section 72(t) is not the most obscure part of the IRA regulations, it can be tricky to understand.

Jim Straus recently found that out. Laid off a few months ago at 53, he began considering taking early retirement and spending his time managing his stock portfolio. He wanted to know the best way to get the money out of his IRA if he needed it right away.

An article in his local newspaper tipped him off about Section 72(t) withdrawals so he went to the IRS Web site for more information. "I had to drill down for a while to find any information. They didn't make it easy," he said.

Even after spending the majority of a day researching the topic, he still missed the answer to an important question on his mind. He wanted to know if these withdrawals would force him to drain his account by the time he reaches 59½.

"The information wasn't clear," said Straus.

How It Works

The IRS says if you set up periodic payments, you must continue them for five years or until you reach age 59½, whichever is longer. So, if you start taking withdrawals at age 57, you won't be able to stop until you reach age 62. Similarly, if you begin withdrawing money at 53, you will have to continue until age 59½.

While your withdrawals will be penalty-free, you will still owe applicable federal and state taxes on your income.

The IRS has approved three methods for calculating these withdrawals. The easiest to understand is the re-calculation, or life expectancy, method. Basically, each year you take a payment, you can calculate the precise amount to take by dividing your IRA account balance by the applicable life expectancy (single or joint) from the IRS' approved life expectancy tables. IRS Publication 590 (page 23) explains this calculation method and the life expectancy tables used in the calculations.

Here's the answer Straus wanted. Because you are calculating the withdrawals over your life expectancy and the IRS tables used in this formula assume a life expectancy well into the 80s, your account balance should last after 59½.

Here's a quick example. Suppose you are 55, with a $500,000 IRA balance. If you are using a single life expectancy, your life expectancy divisor is 28.6. Dividing $500,000 by 28.6 gives you a withdrawal of $17,483.

The other withdrawal formulas would offer you somewhat more flexibility in the amount you can withdraw but they are also more complex. Regardless of the equation you use, you should probably see a CPA to help you with them, advises Certified Financial Planner Mari Adam, in Boca Raton, Fla.

"I wouldn't do this myself," she said. "If there is a mistake, it could cost more (in penalties) than the cost of a CPA."

"You can't do it four years and say 'I don't want to do it in year five.' The IRS doesn't have a sense of humor. This is a contract." — Mari Adam, certified financial planner in Boca Raton, Fla.

Indeed, once you start taking periodic payments, you have to see them through until you satisfy the 59½ or five-year rule. If you want to stop early, all of your payments will be considered early withdrawals and subject to the 10 percent early withdrawal penalty and any interest.

"You need to take it seriously," Adam said. "You can't do it four years and say 'I don't want to do it in year five.' The IRS doesn't have a sense of humor. This is a contract."

Other Considerations

Section 72(t) withdrawals only apply to the IRA from which you are planning to take withdrawals. (This is different from rules for required minimum distributions, which take effect at age 70½ and apply to all your IRA balances combined.)

So, if you need a specific amount that is more than the periodic payment determined by the formulas, you may have difficulties with this strategy. If you have several IRAs, one way around this is to try to consolidate them into a single account so your balance is higher and you can withdraw a larger payment. You could also achieve this by rolling money from an employer-sponsored plan into your IRA, if you have it.

Similarly, if you need an amount less than the result stipulated by the formulas, you could divide your IRA into two smaller accounts, Adam suggests.

The Roth IRA Strategy

Withdrawing money from a Roth IRA soon after conversion "defeats the whole purpose" of opening it. — F. Dennis De Stefano, certified financial planner with De Stefano Wealth Management of Maui, Hawaii.

If you have a Roth IRA, getting at your money is easier but there are still limitations.

You can withdraw your Roth contributions tax- and penalty-free at any time. If you converted a balance from a traditional IRA into a Roth IRA, however, you have to set up a SEPP in order to withdraw the conversion dollars penalty-free before age 59½. You won't be taxed on these withdrawals because you paid the tax on them when you made the conversion.

In order to take a penalty-free or qualified withdrawal of your earnings from a Roth IRA, your money needs to remain in the account for at least five years and you need to be at least 59½. Because the Roth IRA was introduced in 1998, account holders won't be able to make qualified withdrawals until 2003. Again, you can get around the penalty if you set up a SEPP. But, you will have to pay taxes on the earnings if the account isn't at least five years old, says Bob Keebler, a CPA specializing in Roth IRAs, with Virchow, Krause & Co., LLP of Green Bay, Wis.

The main drawback to using a Roth as a source of early retirement funds, especially if you converted a large traditional IRA balance, is that you will miss out on its tax advantages. When you made the conversion, you paid all the applicable income tax at that time. But, depending on your investment choices, the Roth balance likely won't have had enough time to grow large enough (through interest compounding) to offset those taxes, says F. Dennis De Stefano, certified financial planner with De Stefano Wealth Management of Maui, Hawaii.

Withdrawing money from a Roth IRA soon after conversion "defeats the whole purpose" of opening it, he said. "It has to be seasoned for five years under any scenario to make (financial) sense."

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Copyright © 1996 - 2001 mPower, Inc. All Rights Reserved. Reprinted with permission.