Q: I was laid off from my job last year. I'm 56 years old. Is there a way I can take money from my retirement account without having to pay the 10% early withdrawal tax penalty? – PM via email
In fact, if your money is in your former employer's 401(k) plan, there’s no penalty for tapping it because this isn't considered an early withdrawal. People who leave a job after their 55th birthday can take 401(k) distributions without incurring an early withdrawal penalty.
With IRAs, on the other hand, the early withdrawal penalty almost always applies to any distributions taken before you're 59 and a half. But even with IRAs, there is a relatively painless way around the penalty -- and your age makes you a good candidate for it.
Before explaining this method, let's make one thing clear: Even if you escape the 10% early withdrawal penalty, you will owe ordinary income taxes on any distribution you take from a 401(k) or an IRA.
In general, the last thing you want is to qualify for a penalty-free early IRA distribution. The IRS waives the 10% penalty only if
1) You're totally disabled. To satisfy the IRS that you meet this requirement, a doctor must certify that your disability is expected to result in your death or to be of long-continued and indefinite duration;
2) You're dead. In other words, the withdrawal is actually being taken by your beneficiary;
3) You're taking the withdrawal to pay medical expenses that exceed 7.5% of your adjusted gross income;
4) The Internal Revenue Service is tapping your IRA to cover your unpaid taxes;
or -- and this is the only potentially attractive option --
5) You set up a payment schedule for taking IRA withdrawals in substantially equal chunks over a period of years.
That last option is called a 72(t) distribution. Here's how it works:
You must agree to take a series of 'substantially equal' annual 72(t) distributions from your IRA for at least five years or until you turn 59 and a half, whichever is longer. Since you’re 56, you’d have to take annual distributions for five years, until you turn 61.
But you can’t take any amount you wish. Your distribution is based on your life expectancy. As a result, the amount you can withdraw every year depends on your age, and the size of your IRA.
You have a choice of three life expectancy tables to calculate your 72(t) distribution schedule. The distribution amount can vary dramatically depending on which table you use. You should ask a tax accountant to do this calculation for you and explain all the variables involved. You want to get it right: A 72(t) agreement is a contract with the IRS. If you withdraw more or less than the right amount, you're hit with retroactive penalties plus interest.
A 72(t) rarely works for young people because they have long life expectancies and usually also have relatively small retirement accounts. As a result, their potential 72(t) distribution is too small to be of much financial help -- and they have to take it for so many years that their accounts are likely to be empty long before they retire.
But the same factors work in your favor when you're in your late 50s: Your nest egg is probably larger, so your annual 72(t) distributions may be big enough to meet your present needs; yet you'll only be required to take them for five years. That’s important because if your situation improves, you want to be able to stop taking taxable withdrawals and let your account continue growing tax-deferred.
(This post is based on a column originally published as an AARP ‘Ask the Expert’ Money Makeover.)
(c) Lynn Brenner, All Rights Reserved.