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If you have the money, taking retirement
at age 55 is a tantalizing thought. But, the mechanics of doing so can be a little
tricky. And, if you don't know the tricks of the trade, it can also be expensive.
Knowing there's potential for pitfalls, Rod
Apple, a 54-year-old steel industry executive, is concerned. He doesn't want to mess up
his ability to reach the goal he set 30 years ago. "In my 20s, I decided to retire at
age 55. It was a long-term goal," he said.
After years of working in a business that never shuts,
Apple is just a few months away from getting out of the "high pressure" grind,
as he calls it, and has a few questions.
"It's my understanding that I can make withdrawals
from my 401(k) without penalty. Is that correct? What forms need to be filled out to avoid
future IRS challenges?" he asks.
Apple's questions are common. If he doesn't have the right
answers, he could end up forfeiting a substantial chunk of his 401(k) balance to taxes and
penalties.
Rules and Paperwork
Understanding the rules that allow early retirement is the
first step in preserving your nest egg.
The age 59ý distribution rule says any 401(k) participant
may begin to withdraw money from his or her plan after reaching the age of 59ý without
having to pay a 10 percent early withdrawal penalty.
There is an exception to that rule, however, which allows
workers who retire at age 55 to withdraw without penalty from their 401(k). The exception
also applies to workers who quit or are fired when they are at least 55.
There are two key points early retirees need to know.
First, this exception applies if you leave your job at any time during the calendar
year in which you turn 55, or later, according to IRS Publication 575 (page
29).
Second, you can only take money from the 401(k) plan of
your last employer. That means if you left money in the plan of a former employer,
you'll have to wait until age 59ý to start taking withdrawals without penalty.
Apple also wondered if he needed to fill out any special
paperwork with the IRS. The good news is that he doesn't, says Lynn Phillips, attorney
with Watson Wyatt Research and Information Center. "This is all reported by the payer
of the distribution on the 1099R that is distributed" at the end of the year, she
said. All Apple will need to do is report that information on his Form 1040 along with
Form 5329, which shows the additional taxes owed on distributions from IRAs, annuities and
qualified retirement plans, such as a 401(k).
Phillips said, however, that retirees should check their
1099R to make sure the correct distribution code was entered in box No. 7 on the form. For
the 2000 tax year, you should have a code "01" if you are making an early
retirement distribution. A code "02" will be listed if you took a distribution
as part of a series of substantially equal periodic payments. If the incorrect or no code
is listed, then you could owe a 10 percent early withdrawal penalty — be sure to ask
for a new 1099R with the correct code, which you'll also need for Form 5329.
The Lump-sum Problem
One obstacle many workers face is that their 401(k) plans
aren't set up to provide regular withdrawals.
More than 40 percent of plans wouldn't allow workers to
take installment payments last year, the Profit Sharing/401(k) Council of America reported
in its 43rd Annual Survey of Profit Sharing and 401(k) Plans.
In many cases, the plan document requires that a lump-sum
distribution be paid. That's Apple's problem. "Our plan ... won't let you take
(periodic) distributions," he said.
If you have a six-figure or higher 401(k) balance handed
over to you, beware: you could pay at least 31 percent of your nest egg balance in taxes.
What's more, you'll lose out on your investments' continued tax-deferred growth.
A Solution
There is a somewhat circuitous solution to this dilemma;
but, it's convoluted, so bear with us.
The answer is to roll your 401(k) balance into an
IRA. However, this solution has one big drawback. IRA distribution rules don't let you
make a penalty-free withdrawal if you are younger than age 59ý because IRAs aren't
qualified plans, which do permit these withdrawals. (Penalty-free distributions from your
IRA are allowed only in emergencies; read our ABCs for these exceptions.)
This is Apple's main concern. He plans to roll his lump-sum
distribution over to an IRA. So, how will he get his money out of there?
He will need to set up a payment stream from his IRA. The
IRS allows IRA holders to withdraw money penalty-free from their account at any time if
they set up a withdrawal schedule that allows for substantially equal payments over
the course of their lifetime. This is called annuitizing the withdrawals. The formula for
figuring out substantially equal payments is spelled out in IRS Publication 590
(pages 20 and 23).
There's one catch, though. These payments must be made for
a period of five years or until you reach the age of 59ý, whichever is longer. So, if you
start early retirement exactly at age 55, you will have to take payments until you reach
age 60.
Additionally, the rules specify that you will have to take
an exact amount from the IRA at each distribution; another concern for Apple. What if he
needs more? The IRS has a provision to allow that, says John Fletcher, retirement expert
at Century Business Systems. Apple can increase his payments by using a shorter life
expectancy in his distribution calculations, thereby speeding up his annuity payments.
Again, there is one potential drawback if you don't stop
taking payments after five years. "There is a chance you will run out of life
expectancy ... you will outlive your annuity," Fletcher said.
This is why it is essential, before retiring early, to map
out how your resources will sustain you through a retirement that could last longer than
you expect. You might want to plan to live to 90 or 100, just to be sure. This may require
working longer, or working part-time in retirement, if you don't have a big enough nest
egg saved up.
By the way, if you do decide to return to work, don't
worry. You can still continue with your early retirement payments, says Ted Benna, the
creator of the first 401(k) plan and president of 401(k) Association. |
