Early Ira Exit - individual retirement account early withdrawal - Brief Article - Statistical Data Included

Kiplinger's Personal Finance Magazine, Feb, 2001 by Mary Beth Franklin

RETIREMENT | You can tap your money ahead of schedule with NO PENALTY.

WHEN Gary Greenfield of Amelia Island, Fla., became eligible for early retirement, he jumped at the chance even though he was only 48 years old. His federal pension of about $2,000 a month after taxes was a nice start, but it wasn't enough to live on. Knowing how to tap his IRA early without penalty allowed Greenfield to turn his retirement dreams into reality.

Normally, if you withdraw funds from a traditional IRA before you're 59 1/2 years old, you're hit with a 10% penalty--on top of having to pay income tax on the money in your top tax bracket. But there is a way to crack your retirement nest egg while dodging that penalty: Take the money in a series of substantially equal payments based on the amount in the account and your life expectancy.

That's what Greenfield is doing. This exception to the penalty can be the perfect solution if you plan to retire early and need additional income, particularly in the years before social security benefits kick in.

Stick to a schedule. Once you establish an early-withdrawal schedule, you must stick to it for at least five years and until you are at least 59 1/2. So if you started at age 49, as Greenfield did, you'd have to stick to the payout schedule for ten years, so you'd take the final required withdrawal in the year you were 59 1/2. If you were to start using this exception at age 58, however, you'd be required to continue the schedule for just five years. Once you meet the age and five-year limits, you can alter your payout schedule to take more or less.

But if you deviate from your withdrawal schedule, you'll be sorry. Any change after you've begun making withdrawals subjects you to the 10% tax penalty plus interest, which is applied retroactively to all previous withdrawals. That could add up to tens of thousands of dollars.

Choosing a withdrawal method. The IRS has approved three ways for figuring how much you can withdraw penalty-free. The simplest--the life-expectancy method--also produces the smallest payouts. With it, you divide your IRA balance each year by the number of years you're expected to live. Greenfield's IRA held just over $220,000 when he made his first withdrawal in January 2000. At 49, his life expectancy (according to the table in IRS Publication 590, Individual Retirement Arrangements, available at the IRS's Web site, www.irs.gov), was 34 years. So dividing the balance by his life expectancy would have allowed a first-year payout of $6,512. The following year he would divide his new IRA balance by the new life expectancy of a 50-year-old (33.1 years) and so on, meaning his subsequent withdrawals could go up or down depending on whether his IRA balance had increased or decreased during the year.

But Greenfield opted for the amortization method, which allows him to make larger withdrawals based on his life expectancy and a "reasonable" interest-rate assumption on the earnings in his account. When Greenfield entered his data in the IRA Withdrawal calculator at the Retire Early Web site (www.geocities.com/wallstreet/8257/ wdraw59.html), he chose 7.7% as a reasonable interest rate and found he could withdraw $18,475 a year. That's nearly three times as much as with the life-expectancy method.

While the IRS publishes life-expectancy tables, it doesn't set the reasonable interest rate. It has approved using up to 120% of the "long-term applicable federal rate," which was recently 5.82%. A higher rate might prove reasonable to the IRS, too, such as a multiyear average return for the mutual fund in which your IRA is invested. The table above shows how much investors of different ages may withdraw penalty-free based on different interest-rate assumptions.

A third calculation method, the annuity-factor method, can result in even higher withdrawal rates, but it is so complicated you'd probably need professional help to figure it out.

A last resort. Ed Slott, a CPA from Rockville Centre, N.Y., and editor of the IRA Advisor newsletter, says he gets a lot of questions about early IRA withdrawals. He generally tries to talk people out of them unless they are retired, at least 50 years old and in need of income. For someone younger looking to take advantage of an IRA loophole, it's not worth it, he says.

"A 40-year-old would have to commit to withdrawals for nearly 20 years," says Slott. "Most marriages don't last that long." Given the long life expectancies for most people in their thirties and forties, annual IRA distributions would be pretty small.

While tapping your retirement money for anything other than retirement should be your last resort, Slott says that if you really need cash, you'd do better to withdraw the money in one shot, pay the income taxes and the 10% penalty, and be done with it. --Reporter: JOSEPHINE ROSSI

Loophole Early out

For every $10,000 in your IRA, This table shows approximately How much you could withdraw Penalty-free, starting at different Ages. It assumes you use the amortization Method discussed in the Accompanying article with the interest Rates shown.