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Office politics, incessant meetings, and
two-hour commutes. All the familiar frustrations of the rat race. When does it end?
It could end tomorrow if you're 55. You've
reached the age when you can retire and not have to pay a penalty on your 401(k)
withdrawals. But it's not all that simple; you need to know about a few important rules.
Taking early retirement is not as easy as simply quitting
your job.
Financial planner, William Robertson, has a 56-year-old
client with a mid–six-figure retirement balance who wants to retire right now. She's
concerned about whether she has enough money to last throughout retirement and how best to
access that money.
More specifically, Robertson and his client wondered if
there would be a penalty if she took the 401(k) money immediately.
In her case, the short answer is no. For others in a
similar situation, the answer might be yes. Knowing the rules governing 401(k) and IRA
withdrawals might influence the larger question of whether taking early retirement is
right for you.
Avoid Penalties
While you are employed, you can generally begin to withdraw
money from your 401(k) account without a penalty when you reach 59ý. Unless you qualify
for a hardship exemption, you will have to pay a 10% penalty tax to the IRS if you
withdraw money earlier than that.
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"My experience is that most folks
don't understand the amount of money that's required to retire."
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| —F. Dennis
DeStefano, certified financial planner and president of DeStefano Wealth Management. |
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However, the 10% early withdrawal penalty doesn't apply if
you leave the employer with which you have your 401(k) plan after you reach 55. If you are
over 55, but left the employer where you had your 401(k) plan before turning 55, the
penalty tax will apply.
Robertson wanted to make sure his client wouldn't be
snagged by these rules. Luckily, she won't because she's finishing 38 years of service at
the same employer
Next, how do you deal with the money once it's in your
hands? Say you have a $500,000 401(k) account. If you take that all at once, your annual
income will jump into the highest tax bracket. And, depending upon the applicable taxes,
you could lose nearly half of your 401(k) balance.
You want to avoid a big tax hit. If you're lucky, your
401(k) plan will permit periodic withdrawals, allowing you to take out only what you need.
You will still have to pay applicable income tax on that money. But the tax bite should be
lower than if you took a lump sum. You can find out if your plan offers periodic
withdrawals by reading the summary plan document or checking with your benefits
department.
Most employers don't want the administrative hassle of
managing periodic withdrawals and they may require you to take a lump-sum distribution.
This is when an IRA can come in handy. Many financial planners recommend rolling your
401(k) balance directly into an IRA. You won't have to pay any taxes on the lump-sum
transfer, but you'll still have to pay taxes on the money as you take it out of the IRA.
"If you roll your money over into an IRA ... you get
tax-deferred growth," said Matthew Reading, chief investment officer with Austin
Asset Management.
IRA Roadblock
Rolling your lump sum into an IRA does present other
problems. The IRS doesn't allow penalty-free withdrawals from an IRA until after you reach
age 59ý. You are subject to the same 10% early withdrawal penalty as with 401(k)s. But,
there are two ways around this rule.
The first is to take your 401(k) money and buy an annuity.
This insurance-like product guarantees to pay you income for the life of the contract. Click here to find out more about annuities.
One major drawback of annuities is that "they're
inaccessible for an emergency," said Tom Schlossberg, president and CEO of
Diversified Investment Advisors. It doesn't allow you to borrow against it or take out a
larger sum in case you need more money.
Alternatively, you can set up your own payment schedule,
under which you arrange to annually withdraw a fixed amount of money from your IRA or
401(k). The amount you withdraw must be determined by formulae approved by the IRS. These
calculations can be complicated and you may want to consult a professional if you have any
questions or difficulties.
Again, there's one rule you need to know. To avoid the 10%
early withdrawal penalty, the IRS says you must receive payments for at least five years
or until you reach the age of 59ý, whichever is longer. If you're age 58 and start taking
these payments they must continue until you're age 63. If you're age 53, the payments must
continue until you reach 59ý.
This is precisely the strategy Robertson recommended for
his client. He suggested she roll her pension money into an IRA and start taking
distributions over a five-year period. In the meantime, he suggested she leave her 401(k)
money alone, taking it only when needed.
You can actually set up this withdrawal method at any time
with either a 401(k) plan or an IRA. However, you must set up the payment schedule
according to IRS-approved distribution methods.
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| How to Calculate Distributions |
Click here to read IRS Publication
590, which spells out distribution-calculation methods.
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Although you can make these calculations on your own, you
might want to have a professional accountant or financial advisor check your figures.
Starting a five-year distribution program is like waving a red flag before the IRS,
Reading said.
"My experience is these things get audited. If you
pull money out of an IRA and you aren't 59ý, the IRS will audit you to make sure you are
on the level," Reading added.
By the way, even if you've started a five-year payment plan
you may return to work, part time or full time. Also, you can't discontinue the payment
plan, otherwise you will have to pay the 10% early withdrawal penalty.
Early Retirement Now?
Now that you have the early retirement rules in hand, the
next question is whether it's right for you. Will you have enough money?
"My experience is that most folks don't understand the
amount of money that's required to retire," said F. Dennis DeStefano, certified
financial planner and president of DeStefano Wealth Management.
Many financial advisors urge their clients to budget
retirement-living expenses at 70% of those in their working life.
Many folks in their mid-50s see that their 401(k) nest egg
has reached $350,000 and figure that's enough to retire on, said Ted Benna, the creator of
the first 401(k) plan. They expect to take the balance, invest it in something that
provides a 10% return, and have more than enough to live on without touching the
principal. This is a dangerous assumption.
"The erosion of buying power is ignored with that type
of thinking," Benna added.
Suppose inflation is running at 3.5%. A $30,000
annual-401(k) withdrawal today will have the buying power of $15,000 in 20 years, Benna
explains.
If You Wait
Waiting just a few years can really boost your total
balance. If you had a $300,000 401(k) balance at age 55, waited another 10 years to take
retirement, and never contributed another dime to the account, with a 10% rate of return,
your account would grow to $778,122. If you waited five years, under the same conditions,
your account would grow to $483,153.
Many need to resist the temptation to manage their
retirement money too aggressively. With today's easy access to the stock market through
the Internet, many retirees take a lump sum and decide to manage it for themselves.
"When you are trading stocks with your nest-egg money, you need to ask ... do I need
to take that risk?" Reading said.
Often the result is the retiree burns through the nest egg
and in a few years has to return to work.
Hidden Expenses
Early retirees should remember that they won't be eligible
for federal benefits right away. Consequently, they should budget for the time they will
not have these benefits.
Those born after 1943 won't qualify for full Social
Security benefits until they reach age 66. If you were born after 1960, you won't get full
benefits until age 67.
And, Medicare won't pick up your medical bills until you
reach 65. If you retire at 55, you'll need to pay for your health insurance for another
ten years. You may not be able to get coverage at the favorable rates available to
employers.
Even if you've paid off the mortgage on your home, you'll
still have annual-property taxes and upkeep expenses.
One final thought about early retirement. If you haven't
already done so, take a few minutes to assess why you are leaving work. Is it that you
hate your employer or you're genuinely tired of working?
DeStefano asks his clients taking early retirement what
they expect to do during a retirement that could last 40 years. Many folks don't think
that far ahead and quickly get bored and lonely. "Lots of folks are back into the
work force in two years" precisely because they didn't plan how to fill their time,
he said.
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