Early Retirement: IRS-Approved Options for Early Withdrawals

By Frank Armstrong III

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Early retirement may be forced or voluntary. Health, downsizing, a desire to change careers, or a long-held goal of leaving the labor force can drive events. Every case is different. As a general rule, using outside assets may be the preferred way to fund an early retirement. This would leave “qualified” assets to grow tax-deferred and provide the maximum planning flexibility. But not everyone will have the luxury of sufficient liquid assets outside of their retirement accounts. Early retirees will need to explore ways to unlock their retirement plan benefits to sustain them until reaching 59 Qs .

The Case of Eastern and Pan American Pilots

When Eastern Airlines and Pan American Airlines abruptly failed, many of their pilots, faced with the FAA’s mandatory retirement at age 60, were too old to obtain another flying position. Yet they were below the 59 Qs threshold for tapping their retirement assets. The pilots’ plight was complicated by their inability to hypothecate their IRAs or pensions, their lack of W-2 income, and the creditor protection provided by ERISA and state law governing IRAs. All of this combined to make it difficult for the pilots to obtain unsecured loans, in spite of the very substantial retirement accounts that would shortly be available to them.

When working with such individuals, however, the author was able to cobble together secured loans, use outside assets, or design section 72(t) plans that met their needs. In one case, a pilot with no other liquid assets used his credit cards until he reached 59 Qs —only about 12 weeks after the airline failed. The pilot wasn’t a spendthrift, but he had put every available penny into his retirement plans, never anticipating that the failure of his employer would tie up all his savings.

Because many choices are irrevocable, it is imperative that early retirees understand the options, choose wisely, and comply scrupulously. Early retirees must carefully consider their entire financial situation and goals before selecting among the available options. Sound financial planning and competent professional tax advice are essential.

The General Rule and Withdrawal Options

The general rule is simple: a 10% penalty for early withdrawals from pension plans or IRAs prior to age 59 Qs . Not everyone can or wishes to wait that long to retire. Some opt out of the workforce, and some are forced out. Some will find their way back into the labor force, but many will not. Either way, Congress and the IRS have thoughtfully provided them with options to sustain themselves while avoiding the withdrawal penalty.

While the rules are generally similar for both qualified pension plans and IRAs, there are important differences. Two very favorable options are available from qualified plans but not from IRAs. Special tax treatment is available for the net unrealized appreciation (NUA) of employer stock and for distributions directly from a qualified plan to a participant who has “separated from service” after reaching the age of 55. Once a rollover occurs, however, those options are permanently unavailable. So, a knee-jerk rollover might be devastating for some plan participants.

Outside funds. Some retirees may find that they can fund their income needs from separate sources until they reach age 59 1/2 , avoiding the problem of early retirement distributions entirely. This offers the additional benefit of extending the tax deferral advantage of qualified plans or IRAs.

After-tax contributions. Employee after-tax contributions are recovered both tax-and penalty tax–free as taxes have already been paid on those funds. They should be distributed in a separate check given directly to the participant. As of 2002, they may be rolled into an IRA, but this is unlikely to be an efficient choice. Profits on those contributions from the time they were deposited in the plan are subject to the normal tax and penalty provisions.

Death and disability. At any age, distributions from a qualified plan due to a participant’s death or a participant’s total or permanent disability avoid the 10% penalty.

In the case of disability, the participant must qualify under a very strict definition given in IRS Publication 590:

You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

Minor or partial disabilities will not qualify.

In the case of death, distributions to a beneficiary or a beneficiary’s IRA will avoid the penalty. If surviving spouses elect to roll over the funds into their own IRA, however, then they must comply with the normal IRA age 59 1/2 rules or qualify for another IRA exception. If spouses elect to roll over to their own IRA, this is generally considered an irrevocable election and the right to withdraw penalty-free prior to 59 1/2 is lost.

Keep in mind that an IRA can be split into a beneficiary IRA, a spousal IRA, and a partial distribution in order to meet the needs of the spouse. This would be particularly useful where a younger spouse needed some distributions prior to turning 59 1/2 , but wished to stretch out required minimum distributions over a longer lifespan. Making the appropriate split allows the spouse to accomplish both purposes.

Medical payments and insurance premiums. Qualified unreimbursed medical payments exceeding 7.5% of AGI are not subject to the penalty tax if withdrawn from an IRA.

Unemployed persons, or self-employed persons who would qualify for unemployment if not for their self-employment status, may withdraw an amount not to exceed their actual health insurance premiums from an IRA free of penalty. Insurance premium payments may be made for the beneficiary, spouse, and eligible dependents. The individual must have received unemployment payments for at least 12 weeks, and the premium payments must have been made in that calendar year or the following year.

Homeownership. A lifetime exemption for “first-time” homeowner expenses of $10,000 is available free from the penalty. The withdrawals may be made for acquiring, building, or reconstructing a residence for the IRA holder, spouse, children, grandchildren, or ancestors. A first-time home buyer is an individual who has not owned a home for at least the past two years.

Education. Qualifying education expenses for a beneficiary age 18 or older may be withdrawn from an IRA free from penalty. Distribution of original contribution amounts from an Education IRA can always be withdrawn tax-free. Earnings withdrawn and used for qualifying education expenses may be withdrawn totally tax-free if used for tuition payments. Otherwise they are subject to the normal tax and penalty tax.

Roth IRA. Contributions to a Roth IRA can always be withdrawn tax-free because they were made with post-tax funds. Earnings are subject to the normal income tax and penalties unless otherwise qualified for exemption after five years.

Divorce. Distributions pursuant to a property settlement under a qualifying domestic relations order (QDRO) are penalty-free.

Tax levy. If the IRS levies an IRA for unpaid taxes, it is not subject to the 10% penalty.

Separation from service after 55. Individuals with funds in a 401(k) or other qualified retirement plan, may, if permitted by their employer, be able to withdraw assets without penalty, if they were separated from service after age 55. The funds are left in the employer plan and distributed as needed. This might be a great source of funds for individuals retiring between 55 and 59 1/2 .

To qualify, an individual must be 55 when separated from service. One cannot separate before that age and then withdraw funds after age 55. This distribution option is not available for IRAs. As a planning option, an individual may be able to withdraw some funds for living expenses and roll over the rest into an IRA. But once funds are rolled over to an IRA, the opportunity is gone forever.

Note that not all qualified plans allow this. It depends on the plan document. Many employers are anxious to distribute funds to terminated employees rather than bear the cost of administering the plan.

Direct rollovers. A trustee-to-trustee transfer to an IRA will avoid both taxes and penalties. A trustee-to-trustee transfer to another qualified plan will avoid both taxes and penalties. This may be appropriate for a worker changing jobs who does not need current income from the plan. Not all plans will accept rollovers, however.

Rollover within 60 days of receipt from a qualified plan. If a distribution is rolled over into an IRA within 60 days, it will avoid taxes and penalties. If, however, a distribution is made from a qualified plan to a beneficiary under 59 1/2 , the plan is required to withhold 20% for taxes. This can be reclaimed when the beneficiary files a federal income tax return, but all the funds will not be rolled over unless the participant supplies cash to cover the 20% withholding. Doing so is effectively making an interest-free loan to the IRS. If the participant is unable to fund all or part of the withheld 20%, then the balance not rolled over is subject to ordinary income tax and the 10% penalty.

Net Unrealized Appreciation (NUA)

For individuals who own employer stock at a low basis inside a retirement plan, there is a little-known provision that may be very valuable. Employer stock may be withdrawn from the plan with tax owed only on the employee’s basis. When an employee sells the stock, the profit is subject to the favorable 15% long-term capital gains rate.

Even if the distribution is subject to the 10% penalty, this is calculated only on the basis of the stock. If the basis is very low, the penalty tax may be a trivial consideration. The provision may allow an individual to transfer a significant value out of a plan at favorable tax rates with minimal penalties.

If the stock pays dividends, the proceeds are subject to a favorable 15% tax treatment, which is better than if they had accumulated inside the IRA and were then distributed at ordinary income tax rates.

Another important benefit of the NUA strategy is that, for any shares not liquidated after distribution, a step-up in basis is available at death; that means the total appreciation will escape capital gains tax. This advantage is not available to an IRA, and may be a substantial estate planning benefit.

Keep in mind that this special provision for company stock must be part of a total distribution from the plan and must be accomplished within one calendar year. Taxpayers cannot pick and choose shares with different cost bases. Any shares distributed are valued at the average cost basis of the stock. The balance of the distribution may be rolled over into an IRA just like any other total distribution. If the stock is rolled over into an IRA, however, the option is lost forever.

Note that it is important to consider that the distributed shares may represent a substantial concentrated stock position, with all the risks associated with any concentrated position. Normal risk management techniques are essential to prevent potential catastrophic loss due to the undiversified nature of the position.

Substantially Equal Payments: IRC Section 72(t)

If the above options are not available, an individual who has not reached age 59 1/2 can still tap into retirement plan assets under a plan of “substantially equal distributions over your projected lifetime” under IRC section 72(t). The recipient is required to continue distributions until either age 59 1/2 or five years after the start date. If the distributions start at age 50, they must continue until age 59 1/2. But if they start at age 58, they must continue until age 63. Any deviations will be subject to 10% penalties on all previous distributions back to day one, plus interest. With the exception of the one-time conversion explained below, this option is not flexible.

As a result of the market declines from 2000 to 2002, the IRS allowed a one-time conversion to the minimum distribution method, a move to assist individuals who had suffered major losses. This option is limited, because the minimum distribution method provides such small income.

If an account is totally depleted and required distributions cannot be continued, the IRS will not enforce the 10% penalty and interest sections (Revenue Ruling 2002-62). IRC section 72(t) clarifies the maximum “reasonable” interest rate that may be assumed in the amortization and fixed annuity calculations.

IRC section 72(t) provides three ways to calculate allowable withdrawals that provide enough flexibility for almost any reasonable schedule of distributions. They are, in increasing order of distribution size:

• Minimum distribution method. Taxpayers divide their life expectancy or the joint life expectancy with their beneficiary into the balance of the account on December 31 of the previous year. Because life expectancies are so long for people under 59 1/2 , this will generate a very small distribution, typically less than 4%. Because of the annual recalculation based on fluctuating account balances, the amount cannot be exactly determined in advance.
• Fixed amortization. Taxpayers amortize the account over their life expectancy or the joint life expectancy with their beneficiary using a “reasonable” interest rate (defined by Revenue Ruling 2002-62). The rate may not exceed 120% of the federal midterm rate. The life expectancy tables that can be used are: 1) the uniform life table in Appendix A of Revenue Ruling 2002-62; 2) the single life expectancy table in Treasury Regulations section 1.401(a)(9)-9, Q&A-1; or 3) the joint life and last-survivor table in Treasury Regulations section 1.401(a)(9)-9, Q&A-3.
• Fixed annuity method. Taxpayers can use an annuity factor derived from the IRS tables for their life expectancy or the joint life expectancy with their beneficiary. The age annuity factor is calculated based on the mortality table in Appendix B of Revenue Ruling 2002-62 and an interest rate of not more than 120% percent of the federal midterm rate. Once an annual distribution amount is calculated under this fixed method, the same amount must be distributed in subsequent years.

If a calculated distribution is more than a taxpayer needs, an IRA can be split into smaller separate accounts to yield the desired distribution. Later, if the taxpayer needs to, the taxpayer can begin another distribution from another IRA. But each separate distribution will start the clock running for its own five-year/age 59 Qs period.

Using All Available Options

Early retirees often need reliable income to sustain themselves until 59 1/2 . To retain maximum flexibility and extend tax deferrals, most early retirees should explore options other than tapping into retirement savings accounts. If those liquid assets are insufficient, however, a number of alternatives can use the pensioners’ retirement assets without incurring the 10% early withdrawal penalty. Careful planning can usually uncover viable strategies, and scrupulous compliance will avoid potential tax traps.

©2009 The New York State Society of CPAs. Legal Notices