By Chad Carlson
For a growing number of physicians, taking an early retirement is becoming an attractive consideration, but one of the biggest challenges that you may face is how to replace your income after you draw your last paycheck. While many American consider the Internal Revenue Service as an adversary, that's not always the case. For example, let's take a look at Internal Revenue Code Section 72(t).
Internal Revenue Code Section 72(t)
When Congress first created Individual Retirement Accounts (IRAs), they were designed to be long-term retirement savings vehicles. They allowed individuals to save money for retirement during their lifetime in a tax-advantaged manner. In exchange for the tax-deduction on contributions, distributions taken from an IRA prior to age 59 ½ would be subject to a 10% federal income tax penalty as well as ordinary income taxes.
The penalty may be avoided if distributions are taken for any of the following reasons: (1) death or disability, (3) a qualified first-home purchase up to a lifetime maximum of $10 thousand dollars, (4) a rollover or transfer to another IRA, (5) to pay medical expenses in excess of 75% of adjusted gross income, (6) to pay health insurance premiums (subject to certain restrictions), (7) to pay qualified higher education expenses, or (8) as part of a series of substantially equal periodic payments.
Substantially Equal Periodic Payments
Taking a closer look at the last exception, we see that an early retiree may avoid the 10% federal income tax penalty by agreeing to a pre-determined series of substantially equal periodic payments. With the assistance of your investment professional, you can estimate the amount of income you will need and how frequently you will need it. Once you know this figure, you and your tax advisor can determine which calculation method you should use.
The three calculation methods used to determine how much you can withdraw are (1) Amortization - which generally will provide the largest payment, (2) Required Minimum Distribution - which will generally provide the smallest payment, and (3) The Annuity Table - which will generally provide a payment amount somewhere in between.
It's imperative to remember that once a series of payments has started, it cannot be modified. Any changes to your distributions could result in the imposition of the 10% federal income tax penalty plus interest, retroactively applied to the payments beginning with the first year of the distributions. Once an IRA owner has satisfied the five-year holding period or attained age 59 ½, whichever is longer, he or she may, in most cases, stop or alter the payments without becoming subject to a tax penalty.
In order to meet your income objectives, you may want to consolidate multiple IRAs in order to increase the account balance since a larger IRA will yield larger payments. Another option would be to split your IRA into two accounts. This will allow you to use one IRA to provide 72(t) distributions, as well as tailoring the amount of your transfer to provide a specific payment amount. Any additional assets can remain inside of the 2 nd IRA and continue to accumulate tax-deferred.
Are 72(t) distributions the right choice for early retirement?
Due to the strict requirements surrounding 72(t) distributions, most experts would suggest seeking an alternative to using your IRA to produce income prior to reaching age 59½.
In addition to the 10% federal income tax penalty, you forfeit the potential for tax-deferred growth. Remember that IRAs grow tax-deferred, and generally speaking, tax deferred investments will produce a greater accumulation of assets than taxable investments. Nonetheless, if you are planning early retirement, require an immediate income stream, or are experiencing cash-flow problems and do not have alternative income-producing assets, the option to utilize 72(t) distributions may be worth considering.
Chad Carlson is a Financial Advisor with Delta Trust Investments, Inc. For more information, contact Chad at (501) 975-4010 or by email at ccarlson@delta-trust.com. Delta Trust does not offer tax or legal advice and recommends that you consult your tax or legal advisor. |
