Retirement: IRS-Approved Options for Early Withdrawals
- The IRS is relentless and unforgiving of mistakes when it comes
to early withdrawals from pension plans or IRAs. Nevertheless, the
applicable regulations provide options that may be employed to meet
the needs of early retirees. For tax preparers, the key to maximizing
these provisions is careful compliance with the regulations. With
the IRS, an ounce of prevention is worth a ton of cure.
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 .
Case of Eastern and Pan American Pilots
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.
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.
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
General Rule and Withdrawal Options
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.
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.
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.
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.
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:
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.
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.
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.
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.
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.
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.
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.
Distributions pursuant to a property settlement under a qualifying
domestic relations order (QDRO) are penalty-free.
levy. If the IRS levies an IRA for unpaid taxes,
it is not subject to the 10% penalty.
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 .
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.
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.
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,
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.
Unrealized Appreciation (NUA)
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
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.
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
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.
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.
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
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
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
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.
All Available Options
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.
Armstrong III is the founder and principal of Investor
Solutions, Inc., a fee-only, SEC-registered investment advisor (www.investorsolutions.com).
He is also the author of The Informed Investor: A Hype-Free
Guide to Constructing a Sound Financial Portfolio, published