Early Withdrawal - penalties on retirement plans

Black Enterprise, Nov, 1999 by Donald Jay Korn

RICHARD PEACE RECALLS THE TIME ONE OF HIS clients was just fed up with her job. "It happened last year," says Peace, a certified financial planner in Colorado Springs, Colorado. "She was unhappy at work, she was having some health problems and she wanted to spend some time with her young grandchildren. So, she quit her job."

At this point, the grandmother, age 51, needed money for living expenses. "The only asset she could use was her IRA, in which she had accumulated about $75,000. I worked with her and determined she could get by if she pulled out $600 per month, more than $7,000 per year," recalls Peace. "This would leave the rest of her IRA to keep growing."

One of the great temptations that can wreck your retirement is pulling money prematurely from your individual retirement account, 401(k) or 403(b) plan. You know the money is being set aside tax-free to finance your retirement, but the desire to withdraw the funds can be substantial, especially if you're strapped for cash. But the price for pulling money out before you reach age 59 1/2 is pretty high: a 10% penalty and income taxes levied on that money to boot. Peace's client, who withdrew $7,000, might have had to pay a $700 penalty.

"Fortunately, there are several exceptions to the early withdrawal penalty, and my client was able to use one of them," says Peace. Normally, he doesn't recommend clients take money out of their retirement plan before 59 1/2, "but, if you absolutely have to, try to qualify for one of these exceptions and avoid the penalty."

Whether you are in an IRA, 401(k) plan or the nonprofit equivalent, a 403(b) plan, you can pull money out of your retirement coffers under certain dire circumstances: high medical expenses or disability (see table for additional information). These exceptions are explained in Section 72(t) of the Internal Revenue Code. In addition, if someone dies and names you as the beneficiary of a retirement plan, you can withdraw the funds and avoid the 10% penalty, no matter what your age.

IRA AND ROTH IRA WITHDRAWALS UNDER NEW TAX LAWS

                       TRADITIONAL IRA

 Reason for         10% early
 withdrawal    withdrawal penalty?     Taxable?

   Higher              No                 Yes
 Education
 First-Time            No                 Yes
 Home Buyer
 Disability            No                 Yes
  or Death
  For any        Yes, but there           Yes
other reason        are some
                   exceptions
  For any              Yes
   reason

                   FUNDS IN A ROTH IRA
                    FEWER THAN 5 YEARS

 Reason for         10% early
 withdrawal    withdrawal penalty?     Taxable?

   Higher              No            On earnings,
 Education                           not original
                                     contributions
 First-Time            No            On earnings,
 Home Buyer                          not original
                                     contributions
 Disability            No            On earnings,
  or Death                           not original
                                     contributions
  For any         On earnings,       On earnings,
other reason      not original       not original
                  contributions      contributions
  For any                            On earnings,
   reason                            not original
                                     contributions

                    FUNDS IN A ROTH IRA
                    FOR 5 YEARS OR MORE

 Reason for         10% early
 withdrawal    withdrawal penalty?     Taxable?

   Higher              No             On earnings,
 Education                           not original
                                     contributions
 First-Time            No                 No
 Home Buyer
 Disability            No                 No
  or Death
  For any         On earnings,       On earnings,
other reason      not original       not original
                  contributions      contributions
  For any              No                 No
   reason

PAYMENTS WITHOUT PENALTY

Peace's client bypassed the penalty by taking what are called "substantially equal periodic payments" from her

IRA under section 72(t) of the Internal Revenue Code, and it may be the one method most people can benefit from.

In general, 72(t) payments are based on your life expectancy. Once you start receiving funds using this method, they must continue for at least five years, or until you reach 59 1/2, whichever comes later. All Ilia owners can use the 72(t) election at any time, while participants in other plans can use the calculation after retirement or changing jobs. The application of 72(t) rules can vary, depending on your circumstances, producing different distribution amounts.

"There are three methods permitted by the IBS," says Peter Brennan, divisional vice president with Oppenheimer-Funds in New York City. "You can choose among life expectancy, amortization or annuitization."

By basing your periodic payments on life expectancy, you withdraw money based on tables established by the IRS. If your life expectancy is 30 years, for example, you'd calculate 1/30th of your plan balance and withdraw that much each year. Alternatively, you can name a beneficiary and withdraw an amount based on a longer joint life expectancy.