The main concern of people who have retired early or who are thinking of retiring early is often whether or not they have enough money to last the rest of their lives.
Another major concern is their disposable income potential. For one thing, you cannot access Social Security benefits until age 62. Equally difficult is that, unless you qualify for an exception, you cannot withdraw money from IRAs and 401(k) accounts before age 59.5. old, unless you’re willing to accept a 10% tax penalty.
However, according to a IRS statement earlier this year, the agency revised the way it calculates mortality and interest rates. The result is that people who retire before age 59.5 and use one of the exceptions will be able to withdraw more money each year without having to pay the 10% penalty tax.
What has changed
One of the main exceptions that prevents incurring a 10% tax penalty on withdrawals from qualified retirement accounts before age 59.5 is that people use what are called “substantially periodic payments”. equal”, commonly referred to as SEPP. In tax documents, this is referred to as the “72
People using this exception must use one of three different methods to calculate the amount of money they can withdraw from their qualified retirement account and comply with SEPP rules.
The first method, which generates a lower initial withdrawal, is the Required Minimum Distribution (RMD) option. The other two options are the fixed annuity method and the fixed amortization method.
“With the fixed amortization method, your annual payment is determined based on your life expectancy and an allowed interest rate,” said Steve Parrish, assistant professor of advanced planning and co-director of the Retirement Income Center at the University. ‘American College of Financial Services. written in a Kiplinger article. “Due to recent changes made by the IRS, this calculation provides a significant increase in the amount that can be withdrawn each year without incurring the 10% penalty.”
The fixed annuity method, according to Investopedia, is the most complicated of the bunch, but can result in the highest payouts. It includes an account balance, an annuity factor (based on IRS mortality tables and an interest rate), and an annual payment. The retiree then chooses a regular distribution schedule, such as receiving funds monthly, quarterly or annually.
Parrish goes on to explain that what is called the “reasonable rate of interest” used in the past to calculate the benefit was based on low interest rate tables which were published monthly. In December, for example, the rate was 1.52%. Now that the IRS has made its changes, the floor rate is 5%, which provides a much higher payout for anyone trying to maximize the amount they can withdraw each year before incurring the tax penalty, says Parrish. .
“In general, once you have determined how much you are going to withdraw, you should stick with your chosen method for a period of five years or until you reach age 59.5, whichever comes later. “, continues Parrish. “The only exception is that you can switch from one of the other two methods to the RMD method once, which will normally result in a lower payment. This could be useful if you return to work and do not want to plus maximize the amount you withdraw.
A practical example
Right now you’re probably wondering “OK, what’s this really mean?” In his article, Parrish provides this example from tax authority Bob Keebler, a partner at Keebler & Associates, LLP, and current chair of the AICPA Advanced Estate Planning conference.
“Mary is a 50-year-old divorcee who has reached $1 million in her 401(k) account, her retirement savings goal. She would like to retire, and she understands that if she uses the SEPP rule, at age 50 she commits to taking those payments for about 10 years,” Keebler explains. “She wants to use the calculation that is most favorable to her to maximize her withdrawal. Of the three methods, the fixed amortization method provides the largest allowable withdrawal.
Here’s what the new IRS rule means for Mary. If she had started receiving payments in December, before the IRS statement, her payment would have been $36,122, mostly because of the 1.52% interest rate, Keebler says. However, using the floor interest rate of 5%, Mary’s payment would be $60,312.
“There’s more going into the black box used in these calculations, but the net effect is a big change in what it can take out,” Keebler notes.
An important caveat
A strategy for pre-retirees to maximize the amount of withdrawals from eligible accounts without incurring the 10% tax penalty seems like a great idea – at first. However, this brings us back to those lingering worries about having enough money for the rest of your life.
“In my mind, the biggest risk with SEPPs is that you engage in a strategy that can deplete your retirement savings before you run out of oxygen,” Parrish wrote in his post.
“Just because you can now withdraw more each year doesn’t mean you can afford to withdraw that much,” Parrish continues. “For example, if ‘Mary’ withdraws $60,312 each year during the PPSE period, she will likely have exhausted more than half of her $1 million retirement savings by the time she turns 60. She may live decades longer, but she will be starting her 60s on less than $500,000.
If you are retired or planning to retire, be sure to read the rest of our retirement coverage, including