One of the pain points of early retirement is limited access
to your nest egg before age 59½ without incurring a 10% penalty. While a new
IRS rule makes it easier to tap more penalty-free money, you still need to
weigh your options, financial experts say.
Generally, early pre-tax 401(k) or individual retirement
account withdrawals trigger a 10% penalty on top of levies, with several
exceptions, including so-called substantially equal periodic payments, or
SEPPs, a series of distributions for five years or until age 59½, whichever is
longer. These payments are also known as 72(t).
“SEPPs have always been a little-known but effective
strategy,” said certified financial planner Jeff Farrar, executive managing
director of Procyon Partners in Shelton, Connecticut, explaining the appeal for
a retiree in their early 50s with a substantial balance.
Your SEPPs use one of three calculation methods, factoring
in your account balance, a “reasonable interest rate” and you and the account
beneficiary’s ages.
While the IRS previously capped interest to match the
previous two months’ federal mid-term rates, you can now use a higher rate of
5%, according to new guidance, significantly boosting payments.
For example, let’s say you have a $1,000,000 account balance
and you’re age 50 with a 45-year-old spouse who is the beneficiary. For January
2022, the rate was 1.56%, for a maximum SEPP distribution of $36,151 per year.
However, the new 5% rate boosts the annual payment to $59,307.
“It works fine as long as the client understands they need to
maintain that exact draw for the required time,” Farrar said.
However, if you don’t follow the rules, you’ll owe a 10%
penalty on all of your payments, with possible underpayment fees and interest.
The rule of 55
While bigger withdrawals may be attractive, there may be a
better option if you’re age 55 or older with a 401(k) permitting early
withdrawals, said Brian Schmehil, a CFP and senior director of wealth
management at The Mather Group in Chicago.
That’s because of another 10% penalty exception, known as
the “rule of 55,” allowing you to skip early withdrawal fees from your current
401(k) or 403(b) when leaving a job at age 55 or after. And some public service
workers may qualify at age 50.
One advantage of the rule of 55 is there isn’t a set payment
schedule or amount. “The strategy is more flexible than a 72(t) distribution
and will still avoid the 10% early withdrawal penalty,” Schmehil said, assuming
your plan allows it.
Of course, you’ll want to run projections to be sure you can
afford early retirement with either strategy, he said. Then, you can work with
a financial advisor and tax professional to minimize levies and 10% penalties.
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