Making IRA Withdrawals before Age 59½—Without Penalty

An often overlooked rule allows individuals to withdraw early from their IRAs, providing certain conditions are met.

Do you have any clients who need additional income or who have large IRA account balances, including SEP and SIMPLE IRAs, and would like to consider an early retirement? What stops them from taking the money? Many times, it’s fear of the tax consequences of their actions. Most people understand that IRA distributions are taxable, and they also are aware that if they start taking distributions before they turn 59½, they likely will pay an additional 10% early-withdrawal penalty on the taxable portion of the distribution. (After-tax dollars are not taxed when distributed and are not subject to a 10% penalty.)

But they may be mistaken. Internal Revenue Code (IRC) Section 72(t)(2)(A)(iv) permits withdrawals— referred to as “Section 72(t)”  distributions —from IRAs prior to age 59½ without imposing the 10% early withdrawal penalty under the following circumstances:

• Distributions must be made at least annually for five years or attainment of age 59½, whichever comes later.
• Distribution amounts must be determined under one of three IRS-sanctioned methods outlined in IRS Notice 89-25 and substantiated in Revenue Ruling 2002-62.

The distribution method chosen will affect the amount of the annual distribution. What are the three IRS-sanctioned methods?

Method #1: The life-expectancy method, or required minimum distribution (RMD)—Under this method, annual distributions are based on the IRA’s value divided by the life expectancy of the account at the time distributions commence. This method requires an account owner to use one of the tables provided by the IRS, which include “Single Life Expectancy,” “Uniform Life Expectancy,” and “Joint Life and Last Survivor Expectancy” tables.  Distributions fluctuate yearly as the account holder ages and the value of the account changes. This method is the easiest to calculate but generally provides the lowest annual amount.

Method #2: The amortization method—here, the IRA is amortized using a fixed interest rate prescribed by IRS regulations over a term equal to the account owner’s life expectancy. The IRS has ruled that a reasonable rate of interest is not more than 120% of the midterm applicable federal rate.

A different, higher interest rate could be used, but then it would require the account owner to prove the rate selected was reasonable, should the IRS inquire. This method generally provides a larger annual payout compared with the RMD method. Although this method requires a complex calculation, the amount is fixed so the calculation is only performed once.

Method #3: The annuity method is similar to the amortization method, in that it uses the same interest rate and life expectancy, but then introduces a mortality table prescribed by regulation to pay out the IRA account as if it were an annuity. Like the amortization method, the annual payout is fixed at the time distributions commence and does not vary from year to year.

Weighing the Choices
Each method is designed to produce substantially equal periodic payments (SEPP). If an individual elected the amortization or annuity method and used an interest rate that was subsequently deemed not reasonable or if the account owner failed to continue taking the required payments for the requisite time period under any method, the IRS can assess the 10% penalty retroactively to the first year distributions began, as well as impose interest and penalties for underpayment of taxes.

As of February 2015, the IRS’s current monthly interest rate that is used to calculate distributions in the amortization and annuity methods was 2.02%. For example, for a 55-year-old with a $100,000 IRA, the amortization method would produce the largest payout of $4,261 annually until the account owner reaches 59½. Under the same scenario, the annuity method would produce annual payments of $4,248, and the life-expectancy method would produce the lowest annual payout of $2,924. (Lord Abbett offers an online 72(t) payment plan calculator that can be found in the Resource area of our website, under “Retirement Calculators.”)

Different ages and interest-rate changes could produce different results. [Please review all scenarios with a tax professional before initiating a 72(t) pay down for your clients.]

Modifying a SEPP
Government rules require a SEPP to continue for five years or until an individual reaches age 59½, whichever is longer. Once a SEPP commences, an investor is not permitted to make any contributions or additional distributions. Any changes to the account are deemed modifications and could “break” the agreement and subject the plan to extra taxes, penalties and interest.

If, after starting systematic withdrawals, the individual in the example wanted to modify the payments for any reason, including market losses, he/she may do so once by switching to the life-expectancy method, which would then be used for the payment duration. Individuals can switch only once and only to the life-expectancy method. Otherwise, the only ways to stop the withdrawals are to satisfy the later of five years or 59½, or to exhaust the account

Constant-dollar systematic withdrawal plans operating in a down market potentially can deplete an account rapidly. The IRS shows individuals in this situation some mercy. If an individual’s IRA runs out of money before the prescribed time and/or age, the IRS does not consider that a modification that would trigger a 10% penalty on already-distributed funds, assuming the initial payment schedule was followed. Payments can be halted upon the death or injury of the account owner.

Multiple Accounts
The substantially equal payments are distributed from a single IRA or a combination of IRAs. If the 55-year-old individual wants to take an annual amount less than $4,261, based on having more than $100,000 in his/her IRA account, the account could be split into two or more IRAs. The nonpaying IRA(s) could then be utilized if additional distributions were needed at another point before age 59½ under the methods described above, or for some other purpose, including simply being left to accumulate splitting IRAs, in order to have one IRA function as the distribution funding source, avoids tying up more IRA assets than necessary to achieve the desired result.

Any trailing distributions from qualified plans that take place once the Section 72(t) distribution commences should be contributed to a nonpaying (or new) IRA to avoid triggering a modification (e.g., contribution or distribution in excess of the 72(t) calculated amount) of the payment plan and the imposition of the 10% penalty on the amounts already distributed. Similarly, individuals should make new IRA contributions to the non-paying account, to make sure the IRA being used to produce the additional income is not modified.

Roth IRA Conversion
Under the Roth IRA regulations, an amount being received under Section 72(t) can be converted to a Roth IRA without incurring a modification of the payments. Taxes based on the client’s tax rate at the time of conversion would be payable on the entire IRA account balance being converted, and distributions of already taxed money would continue.

Potential Pitfalls
Here’s one trap for the unwary, though. Let’s say our 55-year-old above turns 59½ in 2020 and takes $4,261 per year through 2020. The five-year rule is not satisfied until 2020 ends. This person could not take an additional payment amount from this IRA until 2021 without tax ramifications.

For example, taking an additional $2,000 above the $4,261 after reaching age 59½, but before the end of 2020, would trigger the 10% penalty on all distributions made before age 59½. Prior to beginning payment know your end date.  Further, check each year in December confirming total annual distributions.

A series of substantially equal periodic payments under Section 72(t) can be a very attractive supplemental or retirement income source; but be sure that the tax implications attached to distributions commencing, and perhaps stopping, as well as what can happen to the investment itself, are understood by all parties concerned, especially the taxpayer.