Another Option for Early-Retirement Withdrawals

Christine Benz will be traveling during the next two weeks. While she's out, we'll be rerunning several columns that you may have missed when they first appeared on Morningstar.com.

The recession has hit older workers disproportionately. Although the unemployment rate for people over age 55 is still lower than is the case for under-55 workers, older workers spend a longer time looking for jobs once they've lost them. The typical job search for an over-55 worker lasted nearly nine months, according to a March 2010 Bureau of Labor Statistics report. By contrast, younger workers took less than six months, on average, to replace their lost jobs.

The net effect of sobering statistics like these is that individuals are increasingly forced to raid their retirement accounts to help tide them through hard times. In a report released in late August, Fidelity Investments, the country's largest retirement-plan provider, revealed that the number of plan participants taking hardship withdrawals and borrowing from their 401(k)s had jumped on a year-over-year basis. Workers are tapping retirement accounts to stay in their homes and fund other living expenses as well as to pay for major life changes such as relocation or further education.

In an article last summer, I reviewed some of the options available to those in need of emergency cash before retirement, touching on the pros and considerable cons of 401(k) loans and hardship withdrawals along with the rules regarding IRA withdrawals. The IRA-withdrawal rules are especially complicated, so today I'll focus on one aspect of them in-depth: withdrawals based on the so-called 72(t) exception. Although it's almost never ideal to raid your retirement accounts prematurely, this type of withdrawal may be useful for people who need additional cash to carry them through a specific period in their lives--before they're eligible for a pension or Social Security, for example.

72(t) Basics
In a nutshell, the 72(t) exception allows individuals who are younger than age 59 1/2 to avoid the 10% early-withdrawal penalty for premature IRA distributions. (It does not help you circumvent any taxes owed on the IRA, however--just the 10% penalty.) To take advantage of 72(t), individuals must receive their IRA assets in what the IRS calls "substantially equal period payments" for a period of at least five years. The payments must continue until the age of 59 1/2 or until five years have elapsed, whichever is longer.

The net effect of that rule is that everyone using this exception will need to take withdrawals for at least five years, and younger folks will have to take distributions over many years. A 50-year-old woman, for example, would have to spread her distributions over 9 1/2 years, until she's 59 1/2. Meanwhile, a 57-year-old man who initiates 72(t) distributions would need to take the distributions for five years until he turns 62, well after he'd already hit the 59 1/2-year mark. If you've begun taking 72(t) distributions but later determine you want to stop, you'll owe the IRS the 10% penalties for early IRA distributions, plus interest. For that reason, it's crucial to be sure that substantially equal periodic payments will work for you before embarking on this route.

Note that you don't have to liquidate all of your IRA assets to take advantage of 72(t); if you have separate IRA accounts, you can withdraw from some and leave others alone. (It's also possible to reposition your assets in advance of a 72(t) distribution--that is, leave some money in an IRA to compound and grow while repositioning other assets in short-term securities for 72(t) distributions.) Furthermore, though the majority of people using this distribution method are doing so with traditional IRA assets, it's also possible to apply this distribution method to Roth assets. (This won't often be desirable, however, as I'll discuss later.) Finally, if the bulk of your retirement savings are in the 401(k) plan of a former employer, it's possible to use 72(t) distributions by rolling your assets into an IRA, though there may be certain situations when this isn't desirable or necessary.

Three Methods for Determining Distributions
Nothing is ever simple where the Internal Revenue Service is concerned, so there are three separate methods for calculating your distributions.

The life-expectancy method is identical to the method for calculating required minimum distributions from IRAs and retirement plans: You take your account balance at the beginning of the year and divide it by the life expectancy in the IRS table. The magical IRS Publication 590 has all the details. 

Two other methods for calculating withdrawals, the fixed-amortization method and the fixed-annuitization method, rely on life expectancy plus an assumed earnings rate to determine the payout. These methods generally result in larger payout amounts than that of the life-expectancy method, but they're also more complicated. Check with a competent tax advisor to make sure that you've selected the right method and that you're calculating your withdrawal amounts properly based on the method you've chosen.

Who Benefits and Who Doesn't
As I noted earlier, 72(t) withdrawals will tend to make the most sense for people who need income during a period of years--for example, until they're eligible for another form of retirement income, such as Social Security. And at the risk of stating the obvious, they'll also be best for folks who have an alternate source of retirement funding besides the amount that they're paying themselves through 72(t).

On the flip side, using this withdrawal method can be complicated and paperwork-intensive. It won't make sense for those who need a lump sum to start a business or buy a vacation home because the whole point of 72(t) is that you're receiving payments during a period of at least five years. Nor will 72(t) usually make sense for Roth IRA holders, who have a lot more flexibility in taking withdrawals than do traditional IRA holders, as I outlined in this article.

Finally, those who leave their former employers at age 55 or after and have assets in their old 401(k)s can take penalty-free withdrawals directly from their accounts; rolling the assets into an IRA in order to facilitate 72(t) distributions wouldn't be necessary.

A version of this article previously appeared Sept. 2, 2010.

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