True or False:
Taking money out of a traditional IRA or 401(k) prior to age 59 ½ always triggers a 10% penalty.
You have to be careful whenever questions contains words like "never" or "always". This statement is false. While a pre-mature withdrawal usually incurs a tax penalty there are exceptions to the rule.
Section 72(t) of the Internal Revenue Code allows for penalty free income streams from a tax qualified retirement but, of course, there are some restrictions. First, the government requires that the withdrawals be a series of "substantially equal periodic payments" (SEPP) and the IRS allows three different methods for calculating what that means. You can choose which ever method comes nearest to the amount of income you are looking to withdraw. Secondly, once you choose to make substantially equal periodic payments, you generally have to stick with that election for the LONGER of 5 years or until you reach 59½ otherwise all prior payments under the SEPP are subject to the 10% penalty.
Rather than get caught up in a multitude of details, let's take a look at two real cases I worked on recently to see when and how SEPP elections can be used effectively.
"Jane" is a 57 year old single woman who lost her job in a round of corporate layoffs several months ago. She has been unsuccessfully looking for another job ever since. The only jobs which have been available to her do not pay enough to maintain her lifestyle. Now she is thinking of calling herself retired, drawing retirement income, and supplementing her income with one of those lower paying jobs. She is vested in the pension program of an employer she worked for long ago. She can start drawing from it now but at a lower benefit than if she waited until her mid-60's. Social Security will not be an option until age 62, but she does have a 401(k) with her most recent employer. She can roll over her 401(k) to an IRA and elect to take SEPP withdrawals from the IRA. The IRA income, coupled with her pension income, leaves her short $600 a month but she is confident that she will earn more than that with part time work. She cannot change the 72(t) election for 5 years, but by then she will be 62 and could replace the SEPP income with social security.
"Bob & Mary" are in their late 30's and recently learned that they are expecting their third child. Mary has decided to leave her current job and has accepted a position with another organization where she can job share and work half time. Unfortunately, less time at work means less pay. Bob & Mary were considering withdrawing Mary's six figure 401(k), paying whatever taxes and penalties would be due, applying the remainder to their mortgage, and then refinancing to reduce their monthly mortgage payment. With the size of her 401(k) pushing them up their tax bracket, the federal income tax, state income tax, and the penalties would consume over 45% of the 401(k)! Plus, a significant retirement asset would be gone. I offered the SEPP concept as an alternative. The calculations showed that they would come close to where they need be by supplementing Mary's lower income with a SEPP election. Normally, I would say that it is not a good idea for someone in their 30's to choose and option which is rigid for 20+ years, but in this case they would be drawing a fixed income and using it to pay their mortgage which has more than 20 years of payments remaining.
If improperly set up or modified, SEPP's can trigger a whole new set of problems. While it is not suggested as a do-it-yourself alternative, an experienced financial planner should be able to guide you through the elections benefits and restrictions. For more information on exceptions to premature distributions you are encouraged to consult your attorney or other tax advisor.
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