Q–I was told it is possible to withdraw money from an IRA without penalties before age 59 1/2 if you “annuitize” or take the money out in a series of payments. Assuming this is true, would you recommend it? I am 47 years old and need the money.
Q–I left my old company this year at age 55 and, based on something I read on your column, expected to take my 401(k) plan distribution without penalties. But my human resources department insists there is a 10 percent penalty on withdrawals before age 59 1/2. Could you please cite what section of the tax code you use to back up your position?
A–I get these questions at least once a week, which shows that there is much interest in tapping retirement money before age 59 1/2, and there is also much misunderstanding about the subject.
In particular, it amazes me how many employers incorrectly tell departing employees who are at least 55 that they are subject to a 10 percent penalty on 401(k) plan distributions taken before age 59 1/2.
“That’s an area of the tax code that’s grossly misunderstood,” said Ed Slott, a certified public accountant in Rockville Centre, N.Y. Slott is a widely recognized authority on IRAs and retirement plan distributions who writes and edits the monthly “Ed Slott’s IRA Advisor” newsletter.
Here is the rule from section 72(t) of the Internal Revenue Code: You can take the money you have in an employer’s 401(k) plan and not pay a 10 percent penalty as long as you are at least 55–that’s 55, not 59 1/2–and are “separated from service,” that is, leave your job.
That’s the catch–you cannot stay with the company. But it does not matter whether you quit, get fired or “downsized.” It does not matter whether you retire, go to work for another company, or set up your own business. At age 55, you can take, without penalties, the money on the 401(k) plan of the company you left.
This age 55 rule applies to 401(k) plans, not to IRAs. If you roll your 401(k) plan balance into an IRA, you can no longer use the age 55 rule to take the money out of that IRA.
Before continuing, let me clarify that I am discussing traditional IRAs, not the Roth IRAs that became available in 1998 and have more liberal withdrawal rules. Those who ask about ways to take money out of IRAs usually mean traditional IRAs, which have been around for 25 years and, together with 401(k)s and similar plans, represent a substantial part of many readers’ assets.
Section 72(t) of the tax code also tells how withdrawals from traditional IRAs before age 59 1/2 can escape the 10 percent penalty. One way is to annuitize, or take the money in a series of substantially equal periodic payments that last for at least five years or until you are 59 1/2, whichever is the longer period.
In the case of the 47-year-old who sent in the question at the top of this column, for example, that would mean committing to a withdrawal schedule for 12 1/2 years.
That withdrawal schedule is computed using a formula that takes into account your life expectancy, or that of you and a beneficiary.
You have some flexibility in determining how much you would receive, based on the interest rate assumption built into the calculation (you assume that the money that remains in the account is making interest and growing). But you are still limited as to how much you can withdraw each year. The younger you are, the smaller your withdrawals would be.
Also, once the payments begin, the formula cannot be modified and the payments cannot stop, unless you become disabled or die. Otherwise, you’ve broken the rules and the 10 percent penalty is imposed retroactively.
As you can see, this is a very complicated part of the tax code and you would probably want the advice of a tax professional. Just because you can do something–that is, tapping into your IRA early–doesn’t mean it is a wise thing to do.
“Most people are doing it too quickly,” Slott said. “Annuitizing your IRA early should be used only as a last resort. If you tap it now, what will be left for you when you retire?”
For people with very large IRAs and very little money elsewhere who are ready to retire early, or want to avoid excessive required minimum distributions after age 70 1/2, beginning a series of IRA withdrawals before age 59 1/2 can make sense, Slott said.
But for others, there are likely to be better options.
“The `R’ in IRA is for retirement,” Slott pointed out.
