One of the conundrums faced by anyone who wants to retire early is the 10% additional tax on certain early distributions from many retirement accounts. For example, if you retire at 50, you won’t be able to access pre-tax retirement accounts without incurring the 10% additional tax, unless you qualify for one of the exceptions we’ll discuss below.
Now let’s be certain of one thing – you can access money in a retirement plan anytime, and you will have to include the withdrawal as ordinary income, subject to regular income tax. So what we’re talking about here is the 10% additional tax, which is often referred to as the 10% penalty tax.
Fortunately, there are ways early retirees can access retirement accounts penalty free.
Upon Reaching Age 59 ½
While we tend to think of early retirement as being something that happens at age 55, 50, or even some time before 50, retiring any time much before turning 65 fully qualifies as early retirement. That could be a fortunate thing if early retirement were to happen at age 59 ½ or older.
At that age, you can begin tapping your retirement plan, either an IRA or employer-sponsored plan, without having to pay the 10% early retirement penalty tax. It may even be a strategy worth considering if you plan to retire sometime around or after age 55. The delay can make your withdrawals hassle-free.
A Series of Substantially Equal Payments
You can take retirement distributions from either an IRA or employer-sponsored plan penalty free before reaching age 59 ½ if you structure the distributions as a series of substantially equal payments. In essence, this is setting up an annuity distribution.
Under such an arrangement, the payments must be distributed in substantially equal amounts each year, and based on your life expectancy. The annuity calculation has to be based on an IRS approved distribution method, and must continue for the longer of five years, or until you reach age 59 ½.
There are three different ways that you can take a series of substantially equal payments:
Required minimum distribution (RMD). This is similar to the RMD’s that are required on all retirement plans (except Roth IRA’s) when you reach the age of 70 ½. The calculation takes your account balance at the end of the previous year, then divides it by your life expectancy (based on IRS charts) to arrive at your annual distribution. Because your age and account balance will change every year, the amount of the distribution will also change a little every year.
First amortization method. Under this distribution method, you can create a fixed level annual distribution amount. And like the RMD, it is based on the balance in your account, divided by your life expectancy (based on IRS charts). This method also has a twist. You also have to specify a rate of interest that is not more than 120% of the federal midterm rate published by the IRS in an Internal Revenue Bulletin (IRB).
Fixed annuitization method. This is similar to the last distribution method, except that rather than using your life expectancy to determine annual distributions, you instead use an approved annuity factor. This method also requires that you specify a rate of interest that is not more than 120% of the federal midterm rate published by the IRS in an Internal Revenue Bulletin (IRB).
This will likely be the preferred distribution method for qualified retirement plans for most early retirees. But you should also know that once a distribution plan is established, you cannot deviate from the plan, otherwise it will become null and void and subject you all kinds of unpleasant outcomes. That is to say that these plans won’t allow you to withdraw money from your retirement plans as you see fit.
Separation From Service
Referred to as the 72(t) exemption, separation from service specifically applies to those separated from their employment at age 55 or older, and in regard to their employer sponsored retirement plans, but not IRA’s. This exemption exists if an employee is separated from service during or after the year in which he or she reaches age 55. There is a special provision that allows public safety employees who participate in government defined benefit plans to be exempt under this provision at age 50.
If the reason for your early retirement is permanent disability, you would be able to take withdrawals from either an IRA or an employer-sponsored plan penalty free.
The IRS has a specific definition of permanent disability, which is the inability to “do any substantial gainful activity because of your physical or mental condition”. And naturally, the IRS won’t take your word for it. Your claim will have to be substantiated by a physician, who will certify that your condition is either of an undetermined duration or will ultimately result in your death.
Of course, this is not the optimistic route to early retirement, but if you happened to be heading in the early retirement direction anyway, and had your retirement date moved up due to a disability, it’s good to know that you have options.
For Certain Qualified Expenses
There are certain qualified expenses that fall short of permanent disability that will allow you to make early withdrawals from your retirement savings penalty free. They may be the result of some unpleasant circumstances, but rest assured that life continues to throw curve balls even in early retirement.
Un-reimbursed medical costs. You can withdraw money from your retirement – either an IRA or employer-sponsored plan – to cover the cost of un-reimbursed medical expenses. However, it only applies to the portion of those expenses that exceed 10% of your adjusted gross income. If that sounds familiar, it’s the same threshold that must be reached in order for any of your medical expenses to be deductible on Schedule A of your federal income tax return.
Unemployed medical insurance premiums. Similar to permanent disability, this can work if your early retirement came as a result of losing your job. You can be exempt from the penalty if you use the proceeds to pay for medical insurance in any year which you were unemployed. This includes health insurance purchased for your immediate family. However, the penalty exemption only applies to funds withdrawn from an IRA account, and not an employer-sponsored plan.
The exemption exists if all of the following apply:
- You lost your job.
- You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job.
- You receive the distributions during either the year you received the unemployment compensation or the following year.
- You receive the distributions no later than 60 days after you have been re-employed.
Higher education costs. Once again, the IRS has very specific rules to withdraw retirement money penalty free, and it applies only to funds withdrawn early from an IRA:
“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”
The best bet here for most people will be the series of substantially equal payments. But don’t hesitate to use any of the otherc if they apply in your circumstances.
The IRS offers several resources for those who really want to dive into the details.
Topic 557 – Additional Tax on Early Distributions from Traditional and ROTH IRAs: IRS Topic 557 describes the exceptions to the 10% additional tax on early distributions from traditional and Roth IRAs. Here’s a complete list of the exceptions according to the IRS:
- Made to a beneficiary or estate on account of the IRA owner’s death
- Made on account of disability
- Made as part of a series of substantially equal periodic payments for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary
- Qualified first-time homebuyer distributions
- Not in excess of your qualified higher education expenses
- Not in excess of certain medical insurance premiums paid while unemployed
- Not in excess of your unreimbursed medical expenses that are more than a certain percentage of your adjusted gross income
- Due to an IRS levy, or
- A qualified reservist distribution
Topic 558 – Additional Tax on Early Distributions from Retirement Plans Other Than IRAs: This is where things can get tricky. The rules applicable to an IRA are similar, but not identical to the rules applicable to say a 401k. The following exceptions are similar to what is listed above in Topic 557:
- Distributions made to your beneficiary or estate on or after your death.
- Distributions made because you are totally and permanently disabled.
- Distributions made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary. If these distributions are from a qualified plan other than an IRA, you must separate from service with this employer before the payments begin for this exception to apply.
- Distributions to the extent you have deductible medical expenses that exceed 10% of your adjusted gross income (7.5% if you or your spouse is age 65 or over) whether or not you itemize your deductions for the year. The 7.5% limitation is a temporary exemption from January 1, 2013 to December 31, 2016 for individuals age 65 and older and their spouses. For additional information, see Questions and Answers: Changes to the Itemized Deduction for 2014 Medical Expenses. For more information on medical expenses, refer to Topic 502.
- Distributions made due to an IRS levy of the plan under section 6331.
- Distributions that are qualified reservist distributions. Generally, these are distributions made to individuals called to active duty for at least 180 days after September 11, 2001.
Note, however, that the first time homebuyer exception does not apply to 401k accounts. That’s the bad news. The good news is that 401k accounts offer other exceptions not availably to an IRA (we described the first one above):
- Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50.
- Distributions made to an alternate payee under a qualified domestic relations order, and
- Distributions of dividends from employee stock ownership plans.
Retirement Topics – Exceptions to Tax on Early Distributions: If your eyes are spinning at this point, this resource is for you. The IRS has put together a handy chart describing when the 10% additional tax applies for both qualified plans (e.g., 401k) and other retirement plans (e.g., IRA).