People who retire early need to tap into their retirement savings at an earlier date. As such they are susceptible to pitches from broker-dealers that guarantee comfortable early retirements.

Fleecing of early retirees explained

Table Of Contents

• Ten Percent Tax On Early IRA Withdrawals
• 72(T) Exception To Tax On Early Withdrawals
• Depletion Of Principal
• Substantially Equal Periodic Payments
• Penalty For Excess Withdrawals
• Timing

During such pitches, the broker or investment adviser may promise high levels of withdrawals and high rates of return. The investor should be wary, as early retirement pitches almost always promise too much. They are frequently laden with fraud and deception.

In order to guard against the early retirement ruse, the investor should be informed of the applicable rules. That is the purpose of this article.

The following article explains early withdrawals, tax consequences, and the 72(T) exception.

Ten Percent Tax On Early IRA Withdrawals

As a policy matter, the federal government does not want retirees to withdraw and spend their retirement savings too quickly. This is why the Internal Revenue Service imposes an additional 10 percent tax on early withdrawals from a qualified retirement plan.

The 10 percent tax is in addition to the income tax you pay on most retirement plan withdrawals.

72(T) Exception To Tax On Early Withdrawals

There is a way one can avoid paying the 10% tax penalty.  Section 72(t) of the Internal Revenue Code allows early retirees who withdraw money from their Individual Retirement Accounts (IRA) before age 59 1/2 to avoid the 10 percent penalty.

The early withdrawals must be taken in equal periodic payments.

Depletion Of Principal

Brokers frequently tell retirees that they can take an unreasonably high level of annual withdrawals from their IRA without depleting their principal.  This presupposes the market will grow at a steady rate.

Of course, in reality, the market often declines for extended periods of time.  The broker may tell the client, the market return is 10 %, and we are taking out 8 %, so your money will grow and we will not have to touch your principal.  Sometime later the market goes down, and you are still taking withdrawals at a high level.

This will eventually lead to the depletion of your principal investment.

Of course, the broker did not convey this possibility to you when you first set up the 72(T) withdrawals.  The NASD has stated:

Taking early retirement presents risks, and only makes sense if you have saved enough to begin with, make smart investment choices during your retirement years, and withdraw money at a rate that does not deplete your savings too early.  While there is no perfect consensus on what this withdrawal rate should be, the uncertainty of return, market fluctuations and increased life expectancies among other factors argue for being conservative with your withdrawals, especially during the first years of retirement.  While NASD can make no recommendation, many experts recommend withdrawal rates between 3-5% per year–considerably less than the 7-9% withdrawal rates NASD saw being recommended in the scheme above.

Substantially Equal Periodic Payments

To invoke the benefit of the 72(t) exception, you must take the withdrawals in “substantially equal periodic payments.”

Penalty For Excess Withdrawals

Under the 72(t) exception, If you take out a withdrawal in excess of your normal withdrawal, you violate the “substantially equal periodic payments” rule.  As punishment, you will be subject to a ten percent penalty tax.  The ten percent tax is not limited to the excess withdrawal.

If you take an excess withdrawal, you are taxed ten percent on all of your past withdrawals, even those which were not in excess of the established amount.

For purpose of illustration, suppose a retiree has been taking out $50,000 a year under 72(t).  He has been making this same withdrawal for 2 years.  Then the third year an unexpected expense comes along and he needs an additional $10,000.  So this time he takes a withdrawal of $60,000.

The IRS will impose a 10 percent tax on all the money that was taken out over the past three years, not just the $10,000.  The penalty would be $16,000 — 10% of $160,000.

Timing

You must take the withdrawals at least once a year for five years or until the retiree reaches 59 1/2 –whichever is longer.

Investors sometimes fail to understand this rule, and brokers and investment advisors fail to explain it.  For example, suppose you retire early at the age of 49.  You may believe that you are only required to take out equal payments for the next five years, by which time you will have turned 54.

You are wrong.

The key phrase is “whichever is longer“.  You will have to wait until you turn 59 1/2 to make an excess withdrawal without penalty.  As a result, you will be locked into taking equal payments for the next 10 1/2 years.

What if you retire at 58?  At age 59 1/2 will you be able to withdraw any amount without penalty?  Surprisingly, the answer is no.  You will have to make the withdrawals at the set rate for five years, or until age 63.