A client is leaving his employer. He is over age 55, but not yet age 59 ½, and he will need money from his retirement plan for living expenses. What are his options?
Employees who separate from service in the year they turn age 55 or later can take distributions from their employer plan with no early distribution penalty. This is an exception to the early distribution penalty rules.
Some employer plans will not allow you to take periodic, or ongoing, distributions from the plan. Instead, they require you to take your entire balance all at once. The funds can then be rolled over to your IRA. But distributions from an IRA prior to age 59 ½ will be subject to the 10% early distribution penalty (there are certain exceptions to the penalty).
One option is to set up a series of substantially equal payments (also called 72(t), SEPP, or SOSEPP payments) from the IRA. You can take penalty-free distributions from your IRA as long as you follow the strict set of rules that accompany this exception to the early distribution penalty.
72(t) payments must continue for at least 5 years or until you reach age 59 ½, whichever is later. The 5 years runs until you are 5 years past the date of the first distribution. If the first distribution is made in July 2013, then the schedule is not finished until July 2018, even though you take your fifth annual payment in July 2017 (payment one in 2013, two in 2014, three in 2015, four in 2016, and five in 2017). This trips up a lot of people.
If you do mess up the payment schedule, the 10% early distribution penalty will be owed on all distributions taken prior to age 59 ½. For someone who starts a schedule at age 52, all distributions will now be subject to the penalty. For someone who starts a schedule at age 57, the penalty is capped at all distributions taken for the first 2 ½ years - those prior to age 59 ½.
If you are thinking about setting up this type of payment plan to avoid the 10% early distribution penalty, be sure you work with an advisor who has experience in these types of transactions. There are all sorts of pitfalls not mentioned here that can put you at risk of owing the penalty. You can find a list of Ed Slott trained advisors on our website, www.irahelp.com.
- By Beverly DeVeny and Jared Trexler
Smart money/Coming Soon
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Q:
You recently said that a 401(k) distribution would add to your MAGI (modified adjusted gross income) for the purpose of determining if you are subject to the 3.8% healthcare surtax. What about Roth IRA distributions? Would they also count towards your total MAGI income for surtax purposes?
Thanks
A:
IRA distributions are exempt from the 3.8% surtax, but taxable distributions from IRAs can push income over the threshold amount, causing other investment income to be subject to the surtax. Because Roth IRA distributions are generally tax-free, they don’t count towards your total MAGI.
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2 comments:
I have a had people come to me and become clients because I knew of the issues as discussed above. One client had an advisor who knew to setup the 72 for the client. The advisor was lacking one very critical skill. That skill was around being direct with the client. The client would have run out of money long before she died. The advisor did not seem to know how to present this information. It was my first order of business - determine when we were at or past the five year mark and stop the payments, teach the client to live within her means and even sent her back to work for a while.
Be sure you truly know what you have gotten yourself into.
Wow - it definitely sounds like working with an adviser is the right way to go here. One wrong step and you've landed on a landmine of penalties!
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