Q: I am thinking of taking an early retirement package being offered by my employer. I am currently 57 years old, and I have built up a significant nest egg in my 401(k) plan. I have some money saved outside of my retirement accounts, but not enough to live on until I start Social Security. I am worried about paying penalties on withdrawing money from my 401(k) or IRA. Any thoughts?
A: The best piece of advice I could provide to someone in your situation is to do some serious financial planning before deciding to accept the early retirement package. A financial plan can help you figure out if your savings will be able to support the lifestyle you want in retirement. It will also help you identify contingency plans if retirement turns out to be different than you expect.
You should carefully think about how you will use the money in your retirement accounts. As you mentioned, there are penalties on withdrawals from retirement accounts before the age of 59 ½. However, there are a few notable exceptions to this rule. Knowing about these exceptions can help if you think you might need to tap into your retirement savings early.
The most likely exception for your situation is known as the Rule of 55. This rule states that employees can take penalty-free withdrawals from their employer-sponsored 401(k) or 403(b) plan if they retire or are fired by their employer in the calendar year in which they turn 55 or later. But keep in mind a couple of caveats. First, not all employers offer this opportunity and some that do may require you to take everything out of your account at the same time. Second, this rule only applies to your current employer. If you have funds in 401(k) plans with former employers, those funds are not available for Rule of 55 distributions. You can get around this limitation by rolling balances from old plans into the current plan before retiring and electing the Rule of 55.
If the Rule of 55 doesn’t work for you, you might want to consider Section 72(t) withdrawals from your IRA. These withdrawals, usually referred to as Substantially Equal Periodic Payments, or SEPPs, are governed by very strict rules. If you violate the rules on one withdrawal, you will owe penalties on all your previous 72(t) withdrawals. It pays to be very careful.
SEPPs must be calculated using one of three IRS-approved methods: annuitization, amortization, or required minimum distribution. SEPPs must continue for the longer of 5 full years, or until your reach age 59½.
The annuitization and amortization methods are calculated using an interest rate factor. Before January 2022, the factor was calculated as 120 percent of the Applied Federal Mid-Term Rate, or AFR. In January, the rules changed. Now the factor can be the greater of 120 percent of the Applicable Federal Mid-Term Rate (AFR), or 5 percent. The higher the factor, the greater the SEPP.
One of the basic principles of good 72(t) planning is to create the largest payment from the smallest possible account balance. Therefore, one of your first steps is to figure out the minimum amount to have in your IRA in order to generate the payment you need. Since the 72(t) restrictions only apply to the account from which the SEPP is flowing, any amount beyond that minimum should be moved to a different IRA. You can play around with a 72(t) calculator to figure out what that minimum balance should be. A very serviceable calculator can be found at BankRate.com.
Of the three calculation methods, the RMD method usually produces the smallest payment amount, so it is usually not the preferred choice for calculating a SEPP. However, the RMD method can come in handy if for some reason you want to reduce the SEPP midstream. For example, let’s suppose you go back to work and no longer need the SEPP. IRS rules allow a one-time switch from either the annuitization or amortization methods to the RMD method. You may not be able to stop the SEPP completely, but by changing to the RMD method you can significantly reduce the amount of the payment.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that 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 steve@montereypw.com.