Early Retirement: IRS-Approved Options for Early Withdrawals

CPA Journal, The, Oct 2007 by Armstrong, Frank III

The IRS is relentless and unforgiving of mistakes when it comes to early withdrawals from pension plans or IRAs. Nevertheless, the applicable regulations provide options that may be employed to meet the needs of early retirees. For tax preparers, the key to maximizing these provisions is careful compliance with the regulations. With the IRS, an ounce of prevention is worth a ton of cure.

Early retirement may be forced or voluntary. Health, downsizing, a desire to change careers, or a long-held goal of leaving the labor force can drive events. Every case is different. As a general rule, using outside assets may be the preferred way to fund an early retirement. This would leave "qualified" assets to grow tax-deferred and provide the maximum planning flexibility. But not everyone will have the luxury of sufficient liquid assets outside of their retirement accounts. Early retirees will need to explore ways to unlock their retirement plan benefits to sustain them until reaching 59 ½.

The Case of Eastern and Pan American Pilots

When Eastern Airlines and Pan American Airlines abruptly failed, many of their pilots, faced with the FAA's mandatory retirement at age 60, were too old to obtain another flying position. Yet they were below the 59 ½ threshold for tapping their retirement assets. The pilots' plight was complicated by their inability to hypothecate their IRAs or pensions, their lack of W-2 income, and the creditor protection provided by ERISA and state law governing IRAs. All of this combined to make it difficult for the pilots to obtain unsecured loans, in spite of the very substantial retirement accounts that would shortly be available to them.

When working with such individuals, however, the author was able to cobble together secured loans, use outside assets, or design section 72(t) plans that met their needs. In one case, a pilot with no other liquid assets used his credit cards until he reached 59 ½-only about 12 weeks after the airline failed. The pilot wasn't a spendthrift, but he had put every available penny into his retirement plans, never anticipating that the failure of his employer would tie up all his savings.

Because many choices are irrevocable, it is imperative that early retirees understand the options, choose wisely, and comply scrupulously. Early retirees must carefully consider their entire financial situation and goals before selecting among the available options. Sound financial planning and competent professional tax advice are essential.

The General Rule and Withdrawal Options

The general rule is simple: a 10% penalty for early withdrawals from pension plans or IRAs prior to age 59 ½. Not everyone can or wishes to wait that long to retire. Some opt out of the workforce, and some are forced 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 withdrawal penalty.

While the rules are generally similar for both qualified pension plans and IRAs, there are important differences. Two very favorable options are available from qualified plans but not from IRAs. Special tax treatment is available for the net unrealized appreciation (NUA) of employer stock and for distributions directly from a qualified plan to a participant who has "separated from service" after reaching the age of 55. Once a rollover occurs, however, those options are permanently unavailable. 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 ½, avoiding the problem of early retirement distributions entirely. This offers the additional benefit of extending the tax deferral advantage of qualified plans or IRAs.

After-tax contributions. Employee after-tax contributions are recovered both tax-and penalty tax-free as taxes have already been paid on those funds. They should be distributed in a separate check given directly to the participant. As of 2002, they may be rolled into an IRA, but this is unlikely to be an efficient choice. Profits on those contributions from the time they were deposited in the plan are subject to the normal tax and penalty provisions.

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

In the case of disability, the participant must qualify under a very strict definition given in IRS Publication 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 qualify.

In the case of death, distributions to a beneficiary or a beneficiary's IRA will avoid the penalty. If surviving spouses elect to roll over the funds into their own IRA, however, then they must comply with the normal IRA age 59 ½ rules or qualify for another IRA exception. If spouses elect to roll over to their own IRA, this is generally considered an irrevocable election and the right to withdraw penalty-free prior to 59 ½ is lost.