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Avoiding Penalties for Early Retirement
Distributions from an IRA prior to age 59 ½ may be subject
to a 10% IRS penalty in addition to ordinary income taxes.Under Internal Revenue Code 72(t),
there are certain exceptions that will allow the 10% penalty to be waived by
the IRS, such as death, disability, medical expenses greater than 7.5% AGI, Substantially Equal Periodic Payments, etc.
The Substantially Equal Periodic Payments portion of the IRS
Code 72(t) is of particular importance to early retirees, because it allows
a person to access their IRA funds prior to reaching age 59 ½ without paying an
additional 10% penalty.There are
certain conditions that must be met, however, to take advantage of this
exception.The conditions include:
Payments have to be based on
the IRA owner’s life expectancy or joint lifeexpectancy of the IRA owner and his/her beneficiary
Payments
must be substantially equal periodic payments
Payments must be calculated
using an interest rate no more than 120% of the applicable federal mid-term
rate for either of the two months immediately preceding the month the
distribution begins
The IRA owner must continue the
payments for the later of five years or until age 59 ½, whichever is longer
The three methods of calculating the 72(t) SEPP payments
are:
Amortization method – think
of this method the way you would your mortgage.The account balance is “amortized” over the IRA owner’s life
expectancy or the IRA owner and designated beneficiary’s joint life expectancy.The interest rate used cannot exceed 120% of
the applicable federal mid-term rate.
Annuity factor method – The
account balance is divided by an “annuity” factor.The annuity factor can be derived by using up to 120% of the
applicable federal mid-term rate, the attained age of the IRA owner and the
annuity table in Revenue Ruling 2002-62.
Required Minimum Distribution
method – The account balance is divided by the IRA owner’s life expectancy
(use the IRS life expectancy table, either the single or uniform table).Just remember whichever table used must continue
to be used for all subsequent years.
The annuity factor method often
results in the highest income payment and the RMD method usually results in the
lowest income payment.
