Helping bridge a gap between income need and tax penalties
by Scott HoldenScott W. Holden is an Investment Advisor Representative with Centinel Financial Group, LLC in Maynard, MA. He can be reached at 978.461.0090 x24 or by email at :
As many of us have come to appreciate, the IRS offers opportunities for individuals to save for retirement using the benefits of tax-deferred growth, most notably IRAs, 401(k)s, 403(b)s, SEPs, and other qualified savings accounts.
However, one cannot simply tap into those savings before age 59 ½ without paying a withdrawal penalty of 10%. For many individuals, this does not cause a problem because they are on a course to set their desired retirement age and can leave their accounts untouched. For others, some people find themselves forced into an early retirement through company layoffs, health emergencies, or just stopping work in general before the government mandated retirement age of 59 ½. In such case, these individuals are faced with a significant dilemma on what to do to help bridge the gap between tax penalties and the need for early retirement income.
Understanding the Pros and Cons of Bridging the Retirement Gap
There are possible solutions available that can help bridge a gap, such as hardship withdrawals under IRS regulations; but, it is important to note that each solution carries with it pros and cons that must be carefully considered with the help of a qualified financial and tax professional. Each person’s set of circumstances is different and one strategy may not be a wise solution for everyone.
One strategy that has received more attention in recent years is the 72(t) strategy. Under 72(t), qualifying individuals may be allowed to take a Series of Substantially Equal Periodic Payments (SOSEPP) – commonly referred to as 72(t) withdrawals. There are several rules concerning SOSEPPs and the strategies differ depending on what you’re trying to accomplish. The 72(t) strategy might not be appropriate or available if you are not age 55 or older or you do not qualify for any hardship withdrawals under IRS rules. This would also not be appropriate if you need to take a withdrawal in a lump sum. If you can prepare your finances in advance and withdraw from your retirement account in regular installments, this exception may be appropriate and may help you navigate the 10% penalty.
You would still have to pay income tax at your normal ordinary rate on the taxable portion of the distributions, and there are different requirements and calculations depending if you take funds from an IRA or from an employer-sponsored plan, such as 401(k)s or 403(b)s.
At its basic definition, the 72(t) strategy can allow you to access funds from accounts such as an IRA prior to age 59 ½, but the withdrawals need to be calculated and taken in a specific manner.
For the purposes of example, let’s look at IRAs. There are 3 main methods used to determine the withdrawal amounts that you can take specific to IRAs. Again, these calculations are different from those used for other employer-sponsored plans:
- Required Minimum Distribution Method which is based upon your account balance at the end of the previous year, divided by the life expectancy factor from one of three tables. This annual amount will be different each year.
- Fixed Amortization Method that takes the balance of your IRA account and then creates an amortization schedule over a specified number of years, along with a specific rate of interest not more than 120% of the Federal mid-term rate published by the IRS.
- Fixed Annuitization Method which requires you to calculate the balance of your IRA account, and use an annuity factor, which is found in Appendix B of Ruling 2002-62, along with the age you have reached, or will be reaching, for that year. Similar to the Amortization Method above, a rate of interest is chosen that is not more than 120% of the Federal mid-term rate published regularly by the IRS.
The amounts that are calculated under these formulas are your exact figures for account withdrawals and must be adhered to. You are not able to simply choose your own amount and take that amount each year. You must use one of the above methods. There are restrictions and guidelines that also must be applied, particularly concerning situations where there is more than one IRA or a qualified rollover has taken place from another account into an IRA. Use of these options must be put in place prior to executing a 72(t) strategy, which is why it is imperative that proper guidance from a financial and tax professional is consulted during the process.
As we have outlined, accessing one’s retirement accounts early has several disadvantages and should only be used during true times of hardship or necessity. By accessing qualified retirement accounts early, you should realize that you are going against the very purpose of having tax deferred retirement accounts in place to help support your long-term retirement income needs. It is also important to note that many people to this day do not have significant account balances in their qualified plans due to delays in saving. As a result of these savings patterns for many individuals, the amount that could potentially be withdrawn under 72(t) from these accounts may not even be enough to sustain an individual during their time of need.
If you are in a situation where you have plenty of diversified assets saved for retirement, and are not in a dire need for income, this is not the best strategy. You may want to consider withdrawing from your taxable accounts first, such as mutual funds or stock portfolios, thus allowing your tax-deferred accounts to continue accumulating as long as possible.
You may also want to consider looking at any permanent cash value life insurance that you own and if you are able to access that cash value to supplement income during a time of need. Keep in mind that pulling money from the policy will reduce the death benefit, may trigger policy loan or lapse provisions and could impact any estate conservation strategies that the policy is being used for.
Regardless if you are planning on retiring early, or have been forced into an early retirement before age 59 ½, you should have a financial game plan in place that takes into consideration tax issues, the need for retirement income over the long-term, estate conservation issues and overall market and inflation risk. This is where a qualified financial professional can help mitigate as much unnecessary risk as possible and help you determine strategies and projections that may be available for retirement income over the full length of your retirement.
Registered Representative/Securities and Investment Advisory Services offered through Signator Investors, Inc., Member FINRA, SIPC, a Registered Investment Advisor. 160 Gould Street, Suite 212, Needham Heights, MA 02494. 781.446.5000. Offering John Hancock Insurance Products. Centinel Financial Group, LLC is independent of Signator Investors, Inc. and any affiliated companies. This information is provided as general guidance and is not provided as legal, tax or investment advice to the questioner’s situation. Individual situations vary. Please consult your tax, legal or financial advisor for more detailed information and advice.