There’s some new guidance on early IRA withdrawals that pre-retirees should know about. It changes the interest rate on early withdrawals and allows a switch of method. IRAs are wonderful planning tools, since they allow the accumulation of retirement funds on a tax-deferred, or in the case of Roth, tax-free, basis. With the ‘Great Resignation’ in full swing, many are asking when they can take money out of their IRAs as a rollover from their 401(k), 403(b) or 401(a) plans without incurring a penalty.
The basic rules. There are two important dates, or ‘goalposts’ on traditional (not Roth) IRA withdrawals: age 59 ½ and age 72. Between the ages of 59 ½ and 72, an IRA owner may take whatever they want from their IRA. When they make a withdrawal, it is taxable income. Obviously, withdrawals would interface with the IRA owner’s personal situation, like other income, taxes, and cash flow needs. Before age-59 ½ a withdrawal can cause an additional 10% tax on the early withdrawal other than in situations related to specific exceptions, which we’ll cover later in this piece. Required Minimum Distributions (RMDs) must begin at age 72 (actually, on April 1st of the year after you turn age 72). Missing an RMD can cause a 50% penalty, so IRA owners should be vigilant to take their RMD.
Early distributions. There is a 10% additional tax on traditional IRA distributions prior to age 59 ½. Here is a summary of the exceptions:
Of these exceptions, the IRA has recently given guidance on the ‘Substantially Equal Periodic Payments’ (SEPP) method, which allows an IRA distribution pretty much at any age.
SEPP: The early withdrawal loophole. IRS Code section 72(t) allows for an exception to the 10% penalty tax if the participant takes a series of substantially equal periodic payments from their plan or IRA. The rules are quite specific, and a 72(t) should be calculated carefully. In addition, making a 72(t) election is a decision for the greater of 5 years or age 59 ½ (with a little respite from the new rules). Thus, a 55-year old must maintain their 72(t) until they reach age 60.
The IRS, in Notice 2022-06, has set out new guidelines on SEPP on any series of payments commencing after January 1, 2023, or any starting in 2022. The notice also allows person under a previous SEPP calculation to use the new tables and rules.
Three Methods of SEPP. There are three methods for using the SEPP exclusion:
· The RMD method, which takes the account balance at the end of the previous year and divides it by the life expectancy of the IRS life expectancy table. Under this method, the payment starts small, and changes with the account balance and the age of the IRA owner.
· The Fixed Amortization method, which computes the payment over the life expectancy from the IRS tables at an IRS -approved interest rate. If this method is chosen, the payment stays the same.
· The Fixed Annuitization method, which divides the account balance by an annuity factor using age and interest rates approved by the IRS. With this method, the payment also remains the same.
There are multiple variations of 72(t) calculators to look at potential distribution scenarios. Under the old rules in 2021, a 56-year old with $500,000 in their IRA would be able to take $17,921 a year under the RMD method, $22,123 under the Fixed Amortization method, and $21,997 under the Fixed Annuitization method. They’d use the old IRS tables and the low 1.52% Federal rate.
What’s new. A big change to the SEPP rules is a change in the interest rate used. Under the old rules, you had to use 120% of the federal mid-term rate (1.52% for December of 2021). Under the new rules, you can use a rate no more than the greater of:
· 5% or
· 120% of the federal mid-term rate
This makes a big difference in the current low-rate environment. The 5% rate, if applied with the 2021 life tables like the example above, would increase the annual permissible withdrawal to $33,180 under the Fixed Amortization method and $32,862 under the Fixed Annuitization method. (Note this example uses the 2021 life tables).
The Notice also allows a taxpayer to make a one-time switch of their method and recalculate their new SEPP without a penalty. This can be advantageous if a person taking SEPP wants to change their withdrawal.
Multiple IRAs. Note that SEPP applies on a per-account basis and the SEPP ‘switch’ must be flipped on for the greater of 5 years or until age 59 ½, so using multiple IRAs can allow the flexibility to take another SEPP later, or wait until past age 59 ½. In our example above, the 56-year old may only need $24,000 a year, so they could carve about $361,663 into one IRA and take their SEPP at 5%, leaving the remainder to grow for later.
Bottom Line. Early withdrawals got a little easier from the IRS side and we have some flexibility in determining when and how to take early distributions without excess taxes. As always, I’ll try to answer questions: firstname.lastname@example.org.