Safely Cracking The Nest Egg Early

There's a way to tap those funds without paying a penalty

Turn 59 1/2, and you can withdraw whatever you want from an individual retirement account. Touch the stash before then, however, and with a few exceptions such as disability or college bills, you'll face a 10% penalty. When combined with taxes, this means as much as half of your savings could go to the government.

There is a little-known but perfectly legitimate way to avoid the 10% penalty. Known for the section of the federal tax code that sanctions it, 72(t), this early withdrawal plan requires a participant to take an amount out of a retirement account based on life expectancy. The catch is that you must continue for either five years or until reaching 59 1/2--whichever is longer. That means a 58-year-old is locked into receiving annual payments until age 63. A 35-year-old faces 24 1/2 years of drawdowns. Because the payments are calculated according to actuarial tables, you should--barring some investment disaster--have money left in the account when the mandated withdrawals end.

The 72(t) loophole won't help you if you need a big lump sum to start a business or buy a house. However, the stream of cash it produces can be the solution to ongoing obligations such as alimony, child support, or mortgage payments. With 72(t) withdrawals, you can make an early retirement more comfortable. They can be an effective estate planning strategy (see sidebar). Furthermore, 72(t) withdrawals are your only option if you don't qualify for another exemption from the 10% penalty (table).

Of course, you always want to think twice before raiding your retirement savings. Spending the money instead of letting it grow tax-free will leave you poorer in your old age. And because withdrawals are subject to ordinary income taxes, you won't be able to spend every dollar you take out. (The distributions could also push you into a higher tax bracket.) "This should be a last-resort plan," says Ed Slott, editor of Ed Slott's IRA Advisor Newsletter (800 663-1340;

COSTLY MISTAKES. A 72(t) schedule makes the most sense with a traditional IRA. You can do it with a 401(k), but you must have left the company first. And since Roth IRA owners have already paid taxes on their contributions, they can reclaim those dollars--but not the account's earnings--at any time, tax- and penalty-free.

Even if you can afford to spend retirement money, calculating 72(t) withdrawals is complicated. Moreover, if you make a mistake or try to skirt the rules, the Internal Revenue Service can levy a 10% penalty on every cent you take. Because mistakes are costly, it pays to get help. Consulting with an accountant or financial planner should take an hour or two and cost no more than $500.

The first step in making the projection is to figure out how much money you will need annually. Then, see which of the three IRS-approved methods of calculating withdrawals will get you closest to that sum.

The life-expectancy method is the simplest. However, it is generally the least advantageous because it yields the smallest payouts. To figure out yearly withdrawals, divide your account's balance by your life expectancy. You can either use your life span alone or combine your life expectancy with that of your beneficiary. But since your life expectancy changes every year, you need to repeat this exercise annually.

Take a 50-year-old man with a $500,000 IRA. His life expectancy is 33.1 years, according to the actuarial tables in IRS Publication 590. That divided into $500,000 yields a withdrawal of $15,105. But say the man's 49-year-old wife is his beneficiary. Then, he is also free to use a joint life expectancy, which is 39.7 years. In that case, he arrives at a payout of only $12,594.

If the man eschews the joint approach, at 51 he must take his new account balance and divide by 32.1--or his initial life expectancy minus one. On an IRA now worth $510,000, the new payout is $15,888. Alternatively, he can return to the actuarial tables and look up the life expectancy for a 51-year-old. This approach recognizes that for each year you survive, your life expectancy improves a bit. It also produces slightly lower withdrawals.

To generate higher payouts, you might try the amortization method. Instead of taking your actual account balance every year, you assume your money will grow by the same rate, based on a long-term projection published by the government. The IRS allows you to use between 80% and 120% of the federal long-term rate, says Scott Grittinger, a Strong Investments certified financial planner. Currently 6.09%, this rate can be found on page two of the afrs.pdf publication at Assuming the maximum interest rate of 7.31%--that's 120% of the 6.09% federal rate--the 50-year-old above could take $40,467 a year from his $500,000 IRA.

The annuity method almost always nets the highest payouts. That's because instead of dividing your account balance by your life expectancy, you substitute a smaller "annuity factor." Based on your age and the rate at which you think that your investments can grow, annuity factors can be found in UP-1984, mortality tables published by the Conference of Consulting Actuaries (847 419-9090; $15). For the 50-year-old man, the annuity method indeed yields the highest payout--$42,513--using a 7.31% rate, according to Slott.

Most experts favor the annuity method. For one thing, both the amortization and annuity methods generally yield fixed payouts, which make financial planning easier. But the annuity method also lets you use your IRA most efficiently. Take the 50-year-old man with the $500,000 IRA. If he only needs $15,000 a year, the annuity method lets him draw that amount from a balance of only $176,415. That leaves most of the $500,000 IRA unencumbered. To get $15,000 with the life expectancy method requires almost $500,000, while the amortization approach needs $185,338.

For maximum flexibility, if you only need a portion of your IRA, split the account in two. That way, if you require more money than anticipated, you can start 72(t) payments on the second IRA.

Whatever your situation, be sure you can really afford to raid your nest egg. Even if you avoid the 10% penalty, the more you spend now, the less you will have for later.

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