Thinking about early retirement? There are some traps to be aware of when accessing funds from a retirement account before age 59 ½. You may think that early retirement is a wonderful thing. However, the IRS doesn’t agree. The U.S. tax code generally deems age 59 ½ to be the earliest anyone should retire. You could face ugly tax bills when accessing tax-deferred retirement accounts. Most certainly you’ll pay federal income tax and you may even be subject to state income taxes in states that don’t normally tax retirement income. Most importantly there is a 10% premature-withdrawal penalty that needs to be addressed.
The standard 10% premature-withdrawal penalty applies to IRA withdrawals for those under age 59 ½. But the penalty is waived for withdrawals for company plans and 401(k)s once you reach age 55. This is an important planning consideration for an early retiree. You need to check with your employer to determine what they will allow you to do with these funds after you retire. In order to qualify for the penalty exception, you cannot separate from service until you reach age 55. The IRS recently determined that a taxpayer still owed the 10% penalty on funds she withdrew from her company plan after age 55 because she stopped working at age 53. SEP IRAs and SIMPLE IRAs never qualify for the age 55 penalty exemption.
The surest way to access your retirement funds without penalty before age 59 ½ is by taking a series of substantially equal withdrawals, called 72(t) payments. There are three methods of calculating the amount to withdraw – minimum distribution, fixed amortization, and fixed annuitization. You should consult a financial planner or accountant who is familiar with these formulas to make sure they are set up properly. You also need to familiarize yourself with the rules and make sure you follow them. Failure to set up the distributions correctly or to adhere to the rules could result in all distributions becoming subject to the penalty retroactively.