Retirees get bitten in bear markets when they crack open their accounts too soon.
With the current crisis in the financial world, many of us are finding our retirement assets to be worth a lot less than they were one short year ago. Unfortunately, the downturn in the stock market resulting from the crisis may well prompt a return to a problem that arose with the last bear market, in 2000-2002. At that time, many people had enjoyed such a growth in their retirement funds during the halcyon days of the dot-com era that they no longer felt compelled to continue working. Instead, they wanted to access their retirement funds and retire; often decades before they otherwise would have done. Many of these early retirees faced financial disaster as a result of some of the elements of the Internal Revenue Code applicable to early distributions from qualified retirement plans. It would not be surprising if there were large numbers of people who enjoyed the growth in the value of stocks in their retirement plans prior to the current financial meltdown that will have the same type of problem.
The government, as an element of its tax policies, penalizes taxpayers who "prematurely" take money out of qualified retirement plans. The tax penalties for premature withdrawals can make it difficult for those who wish to take early retirement. The problem is caused by the federal income tax treatment of withdrawals from a qualified retirement plan prior to the plan participant's reaching age 59½. The Internal Revenue Code, in section 72(t), imposes a 10% tax penalty on the taxable portion of any withdrawals from a qualified retirement plan if the plan participant making such a withdrawal is under the age of 59½. There are exceptions to this tax penalty requirement, but the application of the exceptions is technical and failure to take all necessary steps to perfect the exception can cause difficulties. Moreover, a drastic downturn in the value of retirement funds as a result of a bear market can cause unforeseen problems to early retirees.
Many participants in defined contribution retirement plans (such as 401(k) plans) do not want to leave their retirement funds in their employer's retirement plan after retirement. Instead, they desire to get their hands on as much of their retirement funds as possible and at the earliest possible time. In many instances, they want to make purchases of second homes, recreation vehicles, boats, and similar items that will make their retirements more appealing. In addition, they prefer to have complete control over their retirement funds, subject only to government-imposed limitations. Why would anyone want to get the maximum amount of their assets withdrawn from their retirement accounts as soon as possible? One possibility is so they can pay the taxes, but avoid the penalty taxes and then reinvest the funds into assets that will not have investment yield taxed at ordinary income rates.
This desire to get control over retirement funds may directly conflict with the tax penalties imposed on distributions prior to age 59½. If a retiree who has not yet reached that magic age retires and takes immediate distribution of her retirement funds, she will pay a 10% tax penalty on the taxable amount taken. On the other hand, if she "rolls over" the funds into a typical Individual Retirement Account, she is limited in the amount she can withdraw. One of the exceptions to the tax penalty provided in section 72(t) of the Internal Revenue Code is when the distribution is:
"part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary . ."
When an employee totally separates from service with the employer after age 55 and takes distribution from the retirement plan, the tax penalty is not charged. Therefore, the problem arises for those plan participants who retire prior to attaining age 55. In order to avoid the tax penalty, they must spread out receipt of their retirement over their life expectancy.
Obviously, retirees of any age who take their retirement distributions in the form of life annuity payments need not worry about tax penalties. Otherwise, they need to make a calculation of the appropriate amount of annual distributions that can be made without the imposition of these tax penalties. In order to make such a calculation, there are several elements that apply: The first is to ascertain the life expectancy of the retiree. Second, they have to know how much money they have in their retirement account. Third, they must make assumptions as to investment yield so they can calculate the annual distributions that can be made taking into consideration life expectancy and the base amount of assets available for investment. The life expectancy tables are published by the IRS. The base amount of assets available for investment is available from the retiree's employer. The investment yield necessary to complete the calculation must be assumed. Unless an investment is available that guarantees a level yield for the life expectancy of the retiree, any investment yield assumption is almost sure to be wrong in the real world.
Now we return to the desire of the retiree to get as much of their retirement assets in their hands as possible without paying additional taxes in the form of tax penalties. Most retirees desire to take as large a portion of their retirement funds in a lump sum as possible, provided there are no adverse tax consequences. This requires them to balance the amounts actually withdrawn against being pushed into a higher federal income tax bracket as well as calculating the maximum amount that can be withdrawn without the 10% tax penalty. During the days preceding the dot-com crash in 2000-2002, many early retirees calculated their withdrawals using high assumptions about investment yields. This enabled them to withdraw large amounts without tax penalty. The IRS has never dictated the maximum amount of investment return that could be assumed, but have required that any such assumptions be "reasonable." Prior to the dot-com crash many retirement accounts had enjoyed double-digit growth. Therefore early retirees, in their desire to get as much out of their retirement plans as possible without tax penalties, assumed that investment yields would continue at such high levels and scheduled their annual withdrawals accordingly. Moreover, they began to live at the standard of living that such large withdrawals would support -- sometimes at a much higher standard than they had prior to retirement! Unfortunately, the IRS rules required that the amount of scheduled withdrawals, once begun, cannot change.