Getting out early
Sometimes life doesn’t turn out as we expect. A friend of mine lost her job last year after more than twenty years at the same company. She felt confident that her experience would allow her to find a job quickly. She soon discovered, however, that finding work as a 57-year-old was harder than she imagined. As the months stretched out and her liquid savings dwindled, she realized she needed to reconsider her financial plans. In particular, she needed to rethink how she was going to use her retirement accounts.
My friend’s situation is not uncommon. More and more people in their mid- to late-50s are finding themselves out of work. Often, they don’t want to leave their communities, so the pool of potential jobs is narrow and shallow. As the job search stretches out, they get frustrated and disheartened. Sometimes they give up and decide to retire early.
If you find yourself in this situation, it is vital that you do some careful financial planning. If you don’t have a plan, find a planner you can trust. If you already have a plan, take the time to do a thorough update.
One of the areas you will want to look at is how you will use your retirement accounts. You probably already know that IRA withdrawals before age 59 ½ are subject to a 10% penalty tax on top of the normal taxes you will pay on withdrawals. But there are some important exceptions to this rule.
For example, participants in employer-sponsored defined contribution plans can invoke the Rule of 55. This rule states that employees who are laid off, fired or who quit their jobs between age 55 and 59 ½ can withdraw money from their company’s 401(k) or 403(b) plan without any penalty. A couple of caveats apply.
First, this rule applies only to your most recent employer’s plan. Any money left in previous employer-sponsored plans will continue to be subject to the 59 ½ rule.
Second, this rule applies only if you leave your job during the calendar year in which you turn 55 or later. If you leave when you are 54, you lose the Rule of 55 option and you will have to wait until you turn 59 ½.
Your plan may impose other limitations on the Rule of 55. For example, some plans do not allow partial withdrawals. Check with your plan administrator to see how the Rule of 55 works for your plan.
Another exception to early withdrawal penalties is something called Section 72(t) withdrawals, also known as “substantially equal periodic payments.” These distributions are governed by some very tricky rules, so getting professional help is a very good idea. If you violate the rules, you will incur severe penalties. Here are some key rules to keep in mind:
- Revenue Ruling 2002-62 lists three methods you may use for determining your Section 72(t) payments: the required minimum distribution method; the amortization method; the annuitization method. We can’t go into the nuances of each method here, so get some help figuring out which method is best for you.
- Once you begin taking 72(t) distributions, they must continue for 5 years or until you reach age 59 ½, whichever is longer, unless you die or become disabled.
- The 72(t) is applicable only to the account for which you calculated your payment. If you take money from a different retirement account, it will be subject to the 10% penalty.
- Once you start 72(t) distributions, you cannot modify the payment schedule. This includes adding to the account or taking extra distribution. If you do, you will void the agreement and the IRS will come after its 10% penalty on all distributions you have taken prior to age 59½.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.