The costs of accessing retirement funds early

Accessing money from your retirement accounts before you reach age 59 can be costly but there are some exceptions.

Many people will look to pull funds from their retirement accounts when cash flow gets tight or a large unexpected expense occurs. When you take money from a qualified account prior to age 59 you will most likely incur a 10 percent federal tax penalty, and here in California an additional 2.5 percent tax penalty which is in addition to any state and federal income taxes that you will also incur. This is one reason why financial planners are always concerned with the amount of emergency savings available for unexpected expenses. You do not want to pay these high costs to access your own money.

There are some exceptions to these rules that are important to be aware of though. For example, death, disability, qualified first time home buyers (up to $10,000), qualified higher education expenses, unreimbursed medical expenses above 7.5 percent of your adjusted gross income, certain distributions to qualified military reservists called to active duty. The exception is for the penalty not the income taxes. The state of California uses the same list of exemptions as the IRS.

Another option is found using IRS code(s), 72(t)(2)(A)(vi). Let’s just call it 72t for short. Using this tax code an individual may take distributions prior to age 59 without incurring a penalty but, you will still incur income taxes. There is some criteria which must be adhered to for this penalty exemption to be allowed. The withdrawals must be made in a series of substantially equal payments of at least five years or until you reach age 59 whichever is later, or may be a one-time lump sum amount.

These distributions may be taken from 401k, IRA, SEP IRA, SIMPLE IRA, and SARSEP IRA accounts. You cannot change amounts or timing midstream as that would disallow the penalty exemption. Note that the SIMPLE IRA would actually incur a 25 percent penalty if made within the first two years of participation. Ouch!

Here is an example. An individual age 55 has a qualified retirement account and under the 72t code withdraws $20,000 annually for each of the next five years. This would be allowed and a penalty would not be incurred. Both state and federal income taxes would be incurred.

Another example would be to take a one-time lump sum and withdraw $100,000 from the account at age 55. This would also be allowed under the 72t code. Again state and federal income taxes would incurred. Taking a lump sum this large would certainly push you into a higher tax bracket and may not be in your best interest.

If a change to amount or timing happens the exemption then would be disallowed and penalties would be incurred. In the first example withdrawals were being made annually. Let’s say in year three you stop taking the withdrawals, a retroactive penalty plus interest would be incurred on all the funds that had been withdrawn prior using the 72t code. Similarly, in the lump sum example, if you made an additional withdrawal before reaching would1 be incurred. In either age 59 penalties and interest situation this would be very costly and obviously should be avoided.

I used the age of 55 in the above examples but the code is not limited to that age. There are also special rules that apply to qualified public safety employees which would require further discussion.

For some people who have an income gap between an early retirement and when they begin receiving social security or a defined benefit pension, it might make sense to utilize the 72t code strategy but, please know that I am not advocating withdrawing funds from your retirement accounts prior to your retirement. This is almost always a bad idea and even if you avoid the penalties, this will likely have a huge impact on your retirement plan.

Sound advice is to make sure you build up your emergency funds to cover three to six months of living expenses. Plan ahead and save for both your accumulation (i.e. college, boat or vacation home, etc.) and retirement goals. Always work with your team of tax, legal and financial professionals, to help you make such vital decisions. Until we talk again, be well.

Dale Immekus is the owner of Dedicated Financial Services and an accredited wealth management advisor. If you have any questions for our panel of financial experts, email News-Sentinel Editor Scott Howell at scotth@lodinews.com or call 209-369-7035.