Tapping into a Retirement Plan
Some early withdrawals are exempt from tax penalties.
BY RICHARD J. ALPHONSO, JD, CPA/PFS, M.S.T., AND ANITA S. FRANK, CPA

In most cases, financial advisors urge investors to keep their retirement funds growing tax-deferred until the participant in the plan reaches the age of  70 1/2, when the IRS requires taxable distributions to be made from an IRA. However, if you have a large retirement plan or IRA balance, but find yourself in need of immediate cash, it may become necessary to change this strategy.

The IRS discourages taking retirement plan distributions prior to age 59 1/2. The discouragement comes in the form of an additional 10% tax on the amount of the distribution. This is in addition to the ordinary income tax paid on the amount of the distribution.

This month, we'll tell you when you can make early retirement plan withdrawals and still avoid the extra tax.

Exceptions to the Tax

The tax doesn't apply if the distribution is made due to the death or disability of the IRA owner. Also, it doesn't apply if the withdrawal is made to purchase a first home for yourself, your spouse, a parent, a child or a grandchild. A lifetime maximum of $10,000 may be withdrawn from your plan for this purpose without incurring the additional tax.

Withdrawals made to pay for certain medical expenses, health insurance premiums when you're unemployed, and for "qualified" higher-education expenses also escape the tax.

What if you need to supplement your income for several years, or if you plan to retire early?

If you calculate the amount of the withdrawals correctly, and "lock-in" the amount to be paid equally over at least 5 years, you can avoid the additional 10% tax on the distributions made prior to your attainment of age 59 1/2.The rules must be followed strictly. Basically, the distributions must be:

• made at least annually or more frequently, such as quarterly or monthly
• calculated using your life expectancy and an IRS-approved method of calculation
• continue until the later of your attainment of age 59 1/2, or until you complete 5 years of payments
• made after you separate from service if the distributions are from an employer-sponsored retirement plan, rather than from an IRA.

For example, under one calculation method, a 56-year- old owning an IRA valued at $1 million today could withdraw approximately $63,000 every year for 5 years without incurring the tax. The $63,000 would be taxed as ordinary income each year, and the withdrawals couldn't vary for the full 5-year period. Keep in mind that this calculation is interest-rate sensitive, and the withdrawal amount would be greater in an environment of higher interest rates.

Divorce Could Have an Impact

What if you divorce before the 5-year period has elapsed, and your ex-spouse is awarded a portion of your IRA? Will you still be required to keep taking the distributions over the five year period, even though you don't own the entire IRA?

The IRS hasn't addressed this in tax law, but indications from private letter rulings are that the IRS would allow a decrease in the amount of the required distributions in this case. Keep in mind that private letter rulings aren't tax law, and the IRS isn't bound by these decisions.

Withdrawals from your IRA or retirement plan prior to age 59 1/2 aren't usually advisable, but if you truly need the money and you follow the correct procedure, you'll accomplish your cash goals without paying additional tax.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., is president, and Anita S. Frank, CPA, tax manager, at The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group {(713) 627-7660} provides personalized, fee-only financial planning, investment management and business consulting services.