New IRS Rules Could Impact Early Retirees
The IRS recently announced changes to the rules for early withdrawals from retirement accounts.
While early retirement is a goal for millions of people, one of the most common obstacles is being able to access your retirement savings. Of course, you must be at least 62 years old to start receiving social security payments, and IRS rules state that you need to be at least 59½ years old to withdraw from a 401(k) or IRA without penalties.
Retirement savings usually go into IRAs or 401(k) accounts because of the tax benefits, but the withdrawal rules typically force early retirees to have other savings or sources of income that will sustain them until they can begin withdrawing the retirement funds without the stiff 10% penalty.
However, thanks to a recent change by the IRS, retirement accounts may become a more viable option for the living expenses of early retirees. While the IRS has not changed the minimum age requirement of 59½ or the 10% penalty, it has changed the rules regarding exceptions that allow for early withdrawals without penalty.
Summary of the Changes
In January, the IRS announced that it is changing the way that mortality and interest rates are calculated. In an indirect way, this change allows for larger withdrawals to be made without triggering the 10% penalty. So while the IRS has not changed the minimum age for withdrawals or the penalty for earlier withdrawals, the exceptions to those rules are now more favorable for early retirees. As a result, it’s possible that retirement before the age of 59½ will be a realistic option for more Americans. That’s great news for anyone who has ample savings in a retirement account that felt useless until the traditional retirement age.
One of the exceptions that allows for penalty-free withdrawals from IRAs and 401(k)s before the age of 59½ involves taking “Substantially Equal Periodic Payments” or SEPP. You may also see this referred to as a 72(t) exception.
If you are using the SEPP exception, you must choose one of three different methods for calculating the amount that you’re allowed to withdraw without incurring a penalty. The three options are:
- The required minimum distribution (RMD)
- The fixed annuitization method
- The fixed amortization method
The required minimum distribution typically results in a smaller withdrawal than the fixed annuitization and the fixed amortization methods.
If you opt for the fixed amortization method, the amount of money that you’re able to safely withdraw without penalty each year will be determined by your life expectancy and a “reasonable interest rate” permitted by the IRS.
Prior to January, the reasonable interest rate was published by the IRS each month. As an example, December’s rate was 1.52%. Now, the floor rate is 5%. As a result, it’s possible to withdraw a significantly larger amount of money under the SEPP exception than it was in the past.
It’s important to note that once you choose one of the three methods, you must stick with the same calculation for five years or until you reach the age of 59½ years old, whichever comes later. However, you can make a one-time switch from the fixed annuitization method or the fixed amortization method to the required minimum distribution.
An example used in an article published by Kiplinger involves a 50-year-old woman with a one million dollar 401(k) balance. If she wanted to maximize the amount she can withdraw each year, under the old rules in December, her withdrawal would have been calculated at $36,122 per year. Under the new rule using the 5% interest rate, she would be able to withdraw $60,312 per year without penalty.
What It Means for Early Retirees
As you can see from the example, the new rule allows early retirees to access more of their retirement savings without penalty. However, there are some very significant details that must be considered. After all, just because you can take more money out of your retirement accounts doesn’t mean you should.
Here are some things to consider:
- As was mentioned earlier, once you begin these withdrawals, there is a level of commitment to keep taking them. While you have the one-time option to switch to the required minimum distribution, you don’t have the option to take money only when it’s needed.
- Depending on your age and the amount that you withdraw, it’s certainly possible that you’ll blow through your retirement savings too quickly and run out of money during your lifetime.
- Although you’ll avoid the 10% penalty on qualified withdrawals, they’re still subject to ordinary income tax.
- This change only impacts the fixed amortization method of calculating substantially equal periodic payments (SEPP). There are other exceptions and other ways to calculate SEPP that result in a smaller distribution and may be more appropriate since the withdrawals will not eat away at your retirement savings so quickly.
Overall, this rule change is positive for early retirees or those who are considering early retirement. However, this doesn’t change the fact that you’ll need to be sure you won’t outlive your savings. We recommend using caution here by being as conservative as possible with the amount you withdraw, especially at an early age. This rule change will be most practical and beneficial for those who have large amounts saved in retirement accounts and not as much in other accounts.
If you’re considering withdrawing from an IRA or 401(k) to make early retirement possible, we recommend consulting with a tax professional to be sure that you’re following the IRS rules correctly and that you’re not overlooking any important details.