Option eases early retirement withdrawals

Early retirees, especially those with higher incomes, are using an increasingly popular strategy to tap their retirement accounts.

The strategy, known as 72(t), enables retirees to withdraw from their retirement accounts without the 10 percent early withdrawal penalty. But exactly which 72(t) payout method you should elect, or even whether you should use the strategy at all, takes some careful analysis.

Section 72(t), from the federal tax code, allows for penalty-free withdrawals before age 59 1/2 through equal periodic payments, but the withdrawals will still be subject to ordinary income taxes.

You can use 72(t) anytime with an individual retirement account. But for a qualified retirement account, such as a 401(k), you can use it only if you no longer work for the employer. Of course, retired federal workers can withdraw funds from their TSP account at age 55 if they've left government service.

The other key to 72(t) is that once you start, you must take out payments for at least five years or until you turn 59 1/2, whichever is longer. For example, if you start at age 50, you must take out equal payments until you reach 59 1/2. If you start at 56, you must make the periodic withdrawals until age 61. After that, you can stop taking out money, or take out whatever amounts you want without penalty until you start your required minimum withdrawals by April 1 of the year following the year you turn 70 1/2.

The equal annual withdrawals must be made using one of three methods allowed by the IRS:

1. The minimum distribution method, or life expectancy method, calls for you to divide the total amount in the account by your single life expectancy, or the joint life expectancy of you and a beneficiary. You can recalculate every year, so the amount will increase or decrease each year depending on how well the account investments do. This method usually provides the smallest periodic payments of the three methods.

2. The amortization method involves selecting a "reasonable" interest rate at which you assume your IRA will grow. Although open to interpretation and different guidelines, one calculation that the Internal Revenue Service won't challenge is if you base the calculation on 120 percent of the federal long-term rate. A recent long-term rate was just more than 6 percent, allowing an interest rate of a little more than 7.2 percent. This method generally produces larger payouts than the minimum distribution method, but the payments are fixed so you can't increase them in order to keep up with inflation. Another approach for fixing a reasonable interest rate is to use the rate of growth of your IRA investments. The IRS doesn't specifically sanction this approach, but it's a reasonable one.

3. The annuity method normally produces the highest payouts. The calculation is based on insurance company mortality tables, but you can use IRS tables. It is possible to use a cost-of-living factor to increase payments, but you must incorporate this before you start 72(t) payouts. It's a good idea to get some professional help if you choose this method.

To determine which method is the best for your needs, decide first how much money you want to withdraw from your IRA or retirement accounts on a 72(t) basis. Then determine which method produces the amount of money closest to that amount. You can't change the method or arbitrarily increase or decrease payouts during the 72(t) period. Such a move negates the entire annuity schedule, and the IRS will retroactively assess a 10 percent early withdrawal penalty, plus interest.

Experts recommend that you try to get the largest 72(t) payouts from the smallest amount of IRA money. For example, say you have $500,000 in an IRA. If using the annuity method produces the amount of income you need using only $250,000, split the IRA into two and make one of them an annuity. That gives you the flexibility to make the second IRA an annuity later if you need additional cash.

As you can see, the 72(t) annuity procedure is complicated, so you'll want to work with your accountant or certified financial planner. Dennis Filangeri, a certified financial planner in San Diego, recommends discussing with your adviser the pros and cons of doing a 72(t) in the first place. It's not for everyone.

For example, if you retire well before age 59 1/2, you'll be stuck with those payouts for a long time, regardless of whether your needs change. If you're close to 59 1/2, it may be better to find an alternative source of funds. And small accounts probably won't provide enough cash.

Plus, it's usually better to let your nest eggs grow tax-deferred as long as possible before cracking them.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at miltzall@starpower.net.