Monday, September 6, 2010

How to Avoid the 10% Penalty on IRA Withdrawals

Are you under 59½ and considering an early retirement? So what’s holding you back? Is it because the majority of your money is tided up in your IRA, and you don’t like the idea of paying the 10% penalty for early distributions? There might be a way around that … IRS Rule 72(t). Section 72(t) of the Internal Revenue Code allows taxpayers of any age to take a series of substantially equal periodic payments without a 10% penalty. The payments must continue for five years or until you reach 59½, whichever period is longer. While you’re receiving the money, you cannot make any changes to the payments. Each IRA stands on it own, meaning that taking 72(t) distributions from one account has no effect on the others. Therefore, if one IRA will produce more income than is needed, you could set up a smaller, segregated account to withdraw from. And in the future, if you need more income, you could begin equal distributions from another account as well. This could provide greater flexibility in meeting your immediate and future income needs. There are three ways to calculate 72(t) distributions:
  • The Minimum Distribution Method is calculated the same way as required minimum distributions when account owners reach their required beginning distribution date. This method will generally produce the lowest annual 72(t) payments since it is based on the longest life expectancy.
  • The Fixed Amortization Method consists of an account balance amortized over your life expectancy. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed in subsequent years. This produces higher payments than the Minimum Distribution Method and gives some security in that the payments are fixed. But the calculation is complicated and there is the risk that the payments will not keep pace with inflation.
  • The Fixed Annuitization Method consists of an account balance, an annuity factor, and an annual payment. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years. This method may at times provide the largest payments, depending on the size of the account and interest rates used. And like amortization method, the payments are fixed.

Is taking advantage of Rule 72(t) a good idea? It could be. After all, it gets you out of paying the 10% penalty. But remember: You’ll still have to pay ordinary income taxes on the distributions, and money you withdrawal from your IRA means that much less for your future needs. And in case you don’t stay with the plan, or modify the payments in any way, you will no longer qualify for the exemption from the 10% penalty. Furthermore, the 10% penalty will be reinstated retroactively, to all prior years.

So before you take advantage of Rule 72(t), I suggest you get a second or even third opinion before signing on the dotted line. Best wishes, George

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