If you're facing prolonged unemployment, a forced early retirement, or another financial problem, you may be thinking about taking money out of your traditional or rollover IRA, or 401(k) or other tax-deferred workplace savings plan.
If you're under 59½, it should generally be a last resort and done with caution. Why? Because of potential short- and long-term damage to your retirement savings.
In the short term, generally you'll owe income tax on withdrawals and potentially a 10% IRS penalty on distributions from qualified retirement plans and traditional IRAs. That could be nearly 40% right off the top of what you withdraw. (This assumes a 28% marginal income tax rate and the 10% IRS penalty, but it will depend on your age and tax situation.)
In the long term, if you take money out of these accounts, there are less assets to potentially grow on a tax-advantaged basis. If you are unable to replenish these accounts with additional contributions at a later date, your future retirement savings could be in jeopardy.
So before you do anything, ask yourself:
- How urgently do I need this money?
- Are there other sources of money?
- Should I be trading future retirement income for current income?
- Can I eliminate some discretionary expenses instead?
- If retired, should I consider returning to work, at least on a part time basis?
Two potentially less-costly options
If you have no choice but to take money from a tax-deferred retirement account, and you're under 59½, there are several exceptions to avoid the 10% IRS penalty. Most are very narrow exceptions for specific kinds of qualified expenses. Two exceptions, however, are more general and can be taken for any purpose as long as certain requirements are met.
The first one allows penalty-free withdrawals from qualified workplace plans such as 401(k)s to participants who separated from service during or after the calendar year in which the participant reached age 55. This exception is particularly useful if you only need to take withdrawals for a year or two and you are between the ages of 55 and 59½. This exception does not apply to IRAs, so if you roll over your assets in the plan to an IRA, you will lose this exception. The exception also does not apply if you separated from service before the year you turned age 55, even if you are now that age or older.
The second exception allows penalty-free distributions by taking them from retirement accounts as part of an ongoing series of "substantially equal periodic payments" (SEPPs) that satisfies the applicable IRS rules.1
The key IRS requirements are:
- You must withdraw the money at least once per year using IRS-approved calculation methods.
- You must continue to take substantially equal withdrawals for five years or until you reach age 59½, whichever period is longer. For younger people, that means you must continue taking payments for a long time, even if you no longer need the money.
- You cannot make any contributions to, or take any other withdrawals from, the account you are using for your SEPPs, even when you reach 59½, until at least five years and one day have elapsed from the start of your SEPP withdrawals. You may, however, make contributions to and take withdrawals from other retirement savings accounts.
- You may only terminate a SEPP early without penalty because of disability or death, or if your account balance is depleted.
Modifying SEPP payments or not meeting applicable IRS requirements will generally result in a retroactive 10% early withdrawal penalty on all previous SEPP distributions, plus applicable interest. Some examples of this are taking additional distributions from the account, making any contributions or other additions to the account (other than investment gains or losses), or making any partial transfers from the account.
The chart below shows how long SEPP withdrawals would need to last based on your age when you began taking them.
How much can you withdraw?
The IRS has rules for calculating SEPP withdrawal amounts. There are three IRS-approved calculation methods:
- Required Minimum Distribution Method: The annual payment amount is determined by dividing that year's account balance by the taxpayer's (and beneficiary's, if applicable) life expectancy factor. The annual distribution amount is recalculated every year.
- Amortization Method: The annual payment amount is the same every year and is determined by amortizing, or liquidating gradually, the account balance over the taxpayer's (and beneficiary's, if applicable) life expectancy, using a fixed interest rate.
- Annuity Method: Similar to the amortization method, the amount is the same each year. It is determined by dividing the account balance by an annuity factor (from an IRS-provided mortality table) based on the taxpayer's age (and beneficiary's, if applicable) and a fixed interest rate.
Each method uses your current age, life expectancy, and account balance to determine the amount that must be withdrawn each year, so generally the younger you are, the smaller your annual periodic payment amount will be.
You can choose to have the SEPP withdrawals taken out of one or multiple accounts, so you do have some control over the amount of money that must be withdrawn.2 Or you can set up a new IRA account for your SEPP withdrawals by first transferring funds from other retirement accounts. For example, if you have a substantial amount in an IRA and you don't want to take distributions based on the entire balance, you can open a separate IRA and transfer a portion of the funds for the SEPP withdrawals.
If you have a workplace savings plan and you are separated from service, first see whether you can take advantage of the age 55 exception noted above. If not, and your plan does not allow SEPPs, and you don't already have an IRA, then you would need to roll some or all of your assets in the plan to an IRA to take advantage of SEPPs.
The right reasons for a SEPP
While there are drawbacks to locking into a SEPP plan, depending on your situation, taking recurring, regular payments may be one option. For example, some factors to weigh when considering a SEPP plan are:
- You are retiring early and need a temporary income "bridge" until other benefits (e.g., Social Security or a company pension plan) start.
- You are within five years of age 59½.
- You can afford to pay the penalties and taxes should you have to stop your SEPP or otherwise fail to meet all the requirements for the required period.
- You intend to use only a small percentage of your retirement assets for the SEPP plan, leaving sufficient assets in other retirement accounts to cover your long-term retirement needs.
Even when a SEPP plan is appropriate, it's important not to trigger a penalty by modifying it (e.g., by ending withdrawals too soon). If your financial situation changes and you don't need the income during your SEPP period, it may be best to consider continuing to take the withdrawals in order to avoid the IRS penalty. You can then save the withdrawals in a taxable account.
Before setting up a SEPP plan, we recommend that you do the following:
- Consult your tax adviser to determine whether a SEPP plan is an appropriate strategy for you and, if so, to help you establish a plan.
- Consider other options, such as reducing expenses or returning to work.
- If money is needed for a short time period, and no other exception is available, compare the total withdrawals and taxes over the length of the SEPP to those of a couple of distributions subject to taxes and the 10% penalty. The younger you are, the more the latter option may be more cost effective in the long run.
- Make sure that you have a retirement plan in place, so you can maintain sufficient retirement assets to help meet your long-term retirement income needs.
- Learn more about the IRS rules regarding SEPP withdrawals in IRS Revenue Ruling 2002-62.