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01/23/07 - Navigating the IRS's Early Withdrawal Maze

By: Frank Armstrong, CFP, AIFA

The IRS is relentless, remorseless, and unforgiving of mistakes made for early withdrawals from pension plans or IRAs. Forget all that stuff about a kinder gentler IRS. You will play by their rules or pay the price. As for the price, it's pretty steep. You really don't want to go there.

The general rule is simple: There is a 10% penalty tax for withdrawals from pension plans or IRAs prior to age 59 ½. Not everyone can or wishes to wait that long to retire. Some folks opt out of the work force, and some are unceremoniously dumped out. Some will find their way back into the labor force, but many will not. Either way, Congress and the IRS have thoughtfully provided them with options to sustain themselves while avoiding the penalty tax.

It's imperative that early retirees understand the options, choose wisely, and scrupulously comply. Because many choices are irrevocable the early retiree must carefully consider his/her entire financial situation and goals before selecting among the available options. Both sound financial planning and competent professional tax advice are essential for a successful outcome.

While the rules are generally similar for qualified pension plans and IRAs there are important differences. Two very favorable options are available from qualified plans that are not available from IRAs. Special tax treatment is available for Net Unrealized Appreciation (NUA) of employer stock and for distributions directly from a qualified plan to a participant that has "separated from service" after attaining age 55. However, once a rollover occurs, those options are gone forever. So, a knee jerk rollover might be devastating for some plan participants.

Outside funds

Some retirees may find that they can fund their income needs from separate sources until they reach age 59 1/2, which avoids the problem of early retirement distributions entirely. This offers the additional benefit of extending the tax deferral advantage of qualified plans or IRAs.

Pretax Contributions

Employee pretax contributions are recovered tax and penalty tax free as taxes have already been paid on those funds. They should be rolled over in a separate check directly to the participant. While commencing in 2002 they may be rolled into an IRA it is unlikely to be an efficient choice. Profits on those contributions are subject to the normal tax and penalty provisions.

Death and Disability

At any age, distributions from a qualified plan due to the death or total and/or permanent disability of a plan participant avoid the 10% penalty.

In the case of disability, the participant must qualify under a very strict definition defined in IRS Pub 590:

You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

Minor or partial disabilities will not suffice.

Death of Participant

In the case of death, distributions to a beneficiary or a Beneficiary IRA will avoid the penalty. However, if the spouse elects to roll over the funds into his/her own IRA then they must comply with the normal IRA age 59 ½ rules or qualify for another IRA exception to the rules. If the spouse elects to rollover to his/her own IRA this is generally considered an irrevocable election, and the right to withdraw penalty free prior to 59 ½ is lost.

Medical Payments

Qualified un-reimbursed medical payments exceeding 7.5% of AGI are not subject to the penalty tax if withdrawn from an IRA.

Medical Insurance Premiums

An unemployed person, or a self employed person that would qualify for unemployment except for his self employment status may withdraw an amount not to exceed his/her actual health insurance premiums from an IRA free of the penalty tax. Payments may be made for the beneficiary, spouse and eligible dependants. The person must have received unemployment payments for at least 12 weeks, and the health insurance payments must have been made in that year or the following year.

Home Ownership

A lifetime exemption for "first time" homeowner expenses of $10,000 is available free from the penalty tax. The withdrawals may be made for acquisition, building, or reconstructing a residence for the IRA holder, spouse, children, grandchildren or ancestors.

Education Expenses

Qualifying education expenses for a beneficiary age 18 or older may be withdrawn from an IRA penalty tax free.

Education IRA

Contributions from an Education IRA can always be withdrawn tax free because taxes were previously paid on those contributions. Earnings for qualifying education expenses may be withdrawn totally tax free otherwise they are subject to the normal tax and penalty tax.

Roth IRA

Contributions to a Roth IRA can always be withdrawn tax free because they were made post tax. Earnings are subject to the normal income tax and penalties unless otherwise qualified for exemption until 5 years.

Divorce

Distributions pursuant to a property settlement under a Qualifying Domestic Relations Order (QDRO) are penalty tax free.

Tax Levy

If the IRS levies your IRA for unpaid taxes, it is not subject to the 10% penalty tax.

Separation from service after age 55

If you have money in a 401(k) or other qualified retirement plan, and you employer permits it, you may be able withdraw assets without penalty if you separated from service after age 55. The funds are left in the employer plan and distributed as needed. This might be a great source of funds if you retire between 55 and 59 ½.

To qualify you must be age 55 when separated. You cannot separate before that age and then withdraw funds after age 55.

This distribution option is not available to IRAs, As a planning option you may be able to withdraw some funds for living expenses to tide you over to age 59 ½ and roll over the rest into an IRA.

Once funds are rolled over to an IRA, the opportunity is gone forever.

Note: Not all qualified plans allow this. It's depends on the plan document. Many employers are anxious to distribute funds to terminated employees rather than bear the cost of administration.

A direct rollover to an IRA

A "trustee to trustee" transfer to an IRA will avoid both tax and penalty tax.

A direct rollover to another qualified plan

A "trustee to trustee" transfer to another qualified plan will avoid both the tax and the penalty tax. This may be appropriate for a worker changing jobs that does not need current income from the plan. However, not all plans will accept rollovers.

Rollover within 60 days of receipt from qualified plan

If a distribution is rolled over into an IRA within 60 days it will avoid the tax and penalty tax. However if a distribution is made from a qualified plan to a beneficiary under 59 ½ the plan is required to withhold 20% for taxes. This can be reclaimed when the beneficiary files his next federal income tax. But, the entire funds will not be available for rollover unless the participant digs into his own pocket to complete the transaction. If the participant does dig into his own funds, he is in effect making an interest free loan to the IRS.

If the participant is unable to fund all or part of the missing 20%, then the balance is subject to ordinary income tax and the 10% penalty.

Net Unrealized Appreciation (NUA)

If you have employer stock at a low basis inside your retirement plan, there is a little known provision that may be very valuable. You may withdraw your employer stock from the plan paying tax only on your basis. Whenever you sell the stock the profit is subject to the very favorable 15% capital gains rates.

Even if the distribution is subject to a 10% penalty tax, it is only based on the basis of the stock. If the basis is very low, the penalty tax may be a trivial consideration.

This provision may allow you to transfer a significant value out of your plan at very favorable tax rates. The lower your average cost basis, the more dramatic the tax savings.

If the stock pays dividends, then they are subject to the 15% favorable tax treatment, which is far better than if they had accumulated inside and IRA and then distributed at ordinary income tax rates.

Another important benefit of the NUA strategy is that for any shares not liquidated after distribution, a step up in basis is available at death. So, the total appreciation will escape capital gains tax. This advantage is not available to an IRA, and may be a substantial estate planning benefit.

Keep in mind that this special provision for company stock must be part of a total distribution from the plan and must be accomplished in one calendar year. You may not pick and choose shares with different cost basis. Any shares distributed are valued at the average cost basis of the stock. The balance of the distribution may be rolled over into an IRA just like any other total distribution. However, if you roll over the stock into an IRA, the option is lost forever.

Note: It's important to consider that the distributed shares may represent a substantial concentrated stock position with all the risks associated with any concentrated position. Normal risk management techniques are essential to prevent potential catastrophic loss due to the undiversified nature of the position.

Substantially Equal Payments - Section 72(t)

If all else fails, and if you have not reached age 59 ½ you still can tap into your retirement plan assets under a plan of "substantially equal distributions over your projected lifetime" under an IRS regulation commonly referred to as Section 72(t). You will be required to continue your distributions until the later of age 59 ½ or five years. So, if you start at age 50 you must continue until age 59 ½, but if you start at age 58, you must continue until age 63. Any deviations will subject you to 10% penalties on all previous distributions back to day one plus interest. So, with the exception of the one time conversion explained below, it's definitely not flexible.

As a result of the market declines of 2000 to 2002, the IRS modified the regs to allow a one time conversion to the minimum distribution method which was useful for accounts that had suffered catastrophic losses. This relief is very limited because the Minimum Distribution Method provides such small income.

Additionally, the IRS has graciously allowed that if an account is totally depleted and required distributions cannot be continued, they will not enforce the 10% penalty and interest sections. See: Revenue Ruling 2002-62

Finally, the regulation clarifies the maximum assumed "reasonable" interest rate that may be assumed in the amortization and fixed annuity calculations (see above).

The regulations give us three ways to calculate allowable withdrawals. Between them you can design almost any reasonable schedule of distributions. Starting from the smallest distributions they are:

Minimum Distribution Method

Divide your life expectancy or the joint life expectancy of you or you and your beneficiary into the balance of your account on December 31 of the previous year. Because life expectancies are so long for people under 59 ½ this will generate for a very small distribution typically under 4%. Because of the annual re-calculation based on fluctuating account balances the amount cannot be exactly determined in advance.

Fixed Amortization

Amortize your account over your life expectancy or your joint life expectancy with your beneficiary using a "reasonable" interest rate. That "reasonable" rate was defined by Revenue Ruling 2002-62. It may not exceed 120 percent of the federal mid-term rate. The life expectancy tables that can be used are (1) the uniform life table in Appendix A of Rev. Rul. 2002-62, (2) the single life expectancy table in §1.401(a)(9)-9, Q&A-1 of the Income Tax Regulations or (3) the joint life and last survivor table in § 1.401(a)(9)-9, Q&A-3 of the regulations.

Fixed Annuity Method

Use an annuity factor derived from the IRS tables for your life expectancy or the joint life expectancy of you and your beneficiary. The age annuity factor is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and a rate of interest that is not more than 120 percent of the federal mid-term rate published in revenue rulings by the Service. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years.

If your calculated distribution is more than you think you will need, you can split your IRA into smaller accounts that give you the distribution you want. Later, if you need to, you can begin another distribution from another IRA. But each separate distribution will start the clock running for its own five-year/age 59 ½ period.

If your calculated distribution is more than you think you will need, you can split your IRA into smaller accounts that give you the distribution you want. Later, if you need to, you can begin another distribution from another IRA. But each separate distribution will start the clock running for its own five-year period.

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