Withdrawing from your IRA before age 59 1/2

Many financial advisers and financial advice columns state that you cannot withdraw funds from your IRA without paying a penalty prior to the age of 59 1/2. Thanks to an important loophole in the IRA legislation, that’s not strictly true.

The loophole is known as a "72t exception". The name is derived from current tax law (Internal Revenue Service Code Section 72t). That section of the tax code states that you can avoid the 10% penalty tax if you take "substantially equal periodic payments." You have to use an IRS bulletin (Notice 89-25) to calculate what the IRS considers to be "substantially equal periodic payments". You must take those payments for a specific number of years (at least 5). The formula to compute acceptable payments is not simple, but if you need to access your IRA stash, it’s worth the effort (ie avoiding a 10% penalty) to compute your acceptable withdrawal rate. A web search for “IRS 72t calculator” will provide a number of online calculators to compute acceptable 72(t) withdrawals for your IRAs.

The IRS term “substantially equal periodic payments” is often abbreviated as SEPP. To take a series of SEPP from your IRA without penalty, you must withdraw money at least once a year, and you must keep taking withdrawals for five years or until you reach age 59½, whichever is longer. As an example, a 40-year-old would need to take withdrawals for twenty years (until age 59-1/2). Anyone over 54-1/2 years old would need to take them for five years (for 5 years which would be past age 59-1/2). Once SEPP is started, you cannot take unlimited withdrawals from your IRA for 5 years and a day. That’s a limitation for people who start SEPP after the age of 54-1/2. It means they can only withdraw their IRA funds consistent with SEPP rules until all 5 years of SEPP withdrawal have been taken. If SEPP withdrawal rules are not followed exactly, you face a 10% penalty and retroactive interest charges.

SEPP and 72(t) rules do not apply to a 401(k) account, but this technicality can be side-stepped if you rollover your 401(k) into an IRA. You need to consider all of the specific details of your 401(k) plan and rollover rules before you do this. Some company 401(k) plans allow more liberal withdrawal rules than those allowed by IRA regulations. Also, some company rollover rules are limiting. But the rollover strategy can be very valuable in many cases.

For more information see Section 8.3 at: http://www.golio.net/Chapter8.html