How to tap retirement funds before age 59½

Many people dream of retiring early, but what if they need to tap into retirement funds before reaching the "golden years"? While withdrawing from an IRA should be a last resort, there are ways to access money from a retirement account penalty tax-free. However, the rules can be tricky, so an investor should do research before making any final moves. Here are three strategies to consider.

There’s a little-known tax code exception that allows employees who leave jobs at age 55 or older to take penalty tax-free withdrawals from 401(k) accounts. The rule applies if you retire, quit, or even get fired.

A few caveats to keep in mind:

• The rule doesn’t apply to funds in an IRA. This means if 401(k) assets are rolled over into an IRA before age 59½, the benefit is lost.
• It also doesn’t apply to funds still held in a previous employer’s 401(k) account. The good news is there may be a workaround to provide early access to those funds: Before leaving a current job, consider whether or not to transfer the assets from any previous 401(k) plans into a current plan (if your current plan accepts rollovers).

• An investor can withdraw contributions to a Roth IRA at any time without incurring income taxes or tax penalties, no matter the investor’s age or reason. Any earnings on the principal, though, are subject to tax penalty if the distribution is made before age 59½ and they don’t meet certain exceptions.
• Withdrawing those Roth IRA contributions may be a useful tool to help bridge the gap between retirement and the date when an investor has penalty tax-free access to funds in their Traditional IRA or 401(k).

If an investor is in the position to retire before age 55 and wants penalty tax-free access to the tax-advantaged funds they’ve invested, Tax Code section 72(t) includes an exception that allows IRA and 401(k) account holders to take a series of payments based on life expectancy, as long as certain criteria is met.

In short, distributions must:

• Be substantially equal from year-to-year.
• Continue for at least five years, or until an investor reaches age 59½, whichever comes later.
• Be calculated according to one of the three IRS-approved methods.

Each of the three distribution methods yields a somewhat different withdrawal amount and the IRS allows an investor to change from either the fixed amortization method or fixed annuitization method to the RMD method, but only once (and does not allow an investor to change from the RMD method to any other method). That means it’s important to choose carefully. An investor could take out too much and wind up with a nest egg that may not sustain them throughout retirement. Or they could take out too little and find themselves having to supplement income with another job.

Here’s how it works: Assume an investor is 50 years old, has a $1,000,000 portfolio, and opts to calculate based upon a single life expectancy, with an interest rate of 1.55%. According to the E*TRADE from Morgan Stanley 72(t) calculator, the annual distribution amount for each method would return:

• Required minimum distribution (RMD) method:  $27,624
• Fixed amortization method:  $36,303
• Fixed annuitization method:  $36,090

Note that the distribution amounts are shown as annual figures, however, an investor may choose to make withdrawals monthly, quarterly, or semi-annually. These payments can begin at any time, for any reason. The rule requires the series of substantially equal periodic payments to last for at least five full years OR until the IRA owner reaches age 59½, whichever is longer. For example, if an investor begins taking payments at age 56 on December 1, 2018, the investor may not take a different distribution or alter the payment amount until December 1, 2023, even though the fifth payment was taken on December 1, 2022.

Any changes to the payment amount prior to meeting the required distribution period may result in a 10% penalty tax, plus interest applied retroactively to all previous payment amounts.

As mentioned above, the IRS has approved three acceptable calculation methods to determine the required dollar amount of the series of payments:

In addition, the IRS requires the interest rate used for 72(t) payments to be less than or equal to the greater of (a) 5% or (b) 120% of the federal mid-term rate for either of the two months immediately preceding the month in which the distribution begins.

Lastly, there are three different life expectancy tables that the IRS allows an investor to use when calculating a 72(t) withdrawal with the fixed amortization or the RMD methods. It is important to note that once a distribution method and life expectancy table have been chosen, an investor cannot change either throughout the course of distributions, except for a one-time change from the fixed annuitization or amortization methods to the RMD method.

It’s worth noting the substantially equal periodic payment provision under Tax Code section 72(t) is extremely complex. If investors or their 401(k) provider’s plan sponsor gets it wrong, the investor could be subject to a modification of the payment stream, where the 10% tax penalty applies retroactively to all previous distributions, plus interest for the deferral period. That’s why it’s so important to be diligent and conscientious when making this decision, and when considering any other retirement plan distribution strategy. E*TRADE from Morgan Stanley does not provide tax advice, so contact your tax advisor for information specific to your situation.

If you decide to take substantially equal periodic payments from your E*TRADE account, you will be responsible for reporting this to the IRS, calculating your payment, and taking distributions on time.

Visit Retirement Planning to learn more about Traditional and Roth IRAs, and take advantage of our educational tools and resources that can help you understand how to plan for retirement. You’ve worked hard. You should be able enjoy it. If you have any retirement questions, please call us at 800-387-2331 to talk with an E*TRADE representative.