Penalty-free way to tap IRA early

But process is complex, so tread carefully

Mike D’andrea knew something was wrong as soon as the client entered his office in Frederick, Maryland.

The client had been laid off and his severance wasn’t enough to carry him until he was 59 1⁄2, the age at which he could tap his nest egg without paying the 10% penalty on early withdrawals from tax-deferred retirement savings plans.

To meet his living costs from the day he left his job until he turned 591⁄2, the client opted to transfer a portion of his retirement savings into a traditional IRA and agreed to withdraw all of the cash in substantially equal periodic payments, or SEPPS.

This strategy — also known as 72(t) — lets retirement account holders avoid the 10% early-withdrawal penalty by taking equal payments for at least five years or until the owner turns 59 1⁄2, whichever is longer.

While such payouts appear to be an easy way to access an IRA penalty free, some financial advisers vociferously steer their clients away from the 72(t) option. Amy Pastorino, a wealth management adviser in New York City, advises clients to consider 72(t) as “your last possible resort” because “it is very, very rigid and a lot can go wrong.”

To start, you must use one of three methods to calculate the size of the payments. The required minimum distribution method is the simplest option — divide the year-end value of assets in your IRA by a lifespan estimate provided by the IRS — but it also typically produces the lowest payment and must be recalculated each year.

The other two options — a fixed amortization approach and fixed annuitization method — also look at assets in hand and years to live but consider interest rate forecasts.

The best option for an investor depends on his or her circumstances, so it is prudent to have a professional help you decide.

After you start taking 72(t) withdrawals from an IRA, you cannot change the size or frequency of the payout. You cannot make additional withdrawals from the IRA you use for the 72(t) distributions, nor can you deposit money into the account. If you withdraw too much or too little or take a distribution too early, the IRS will levy the 10% penalty tax on everything you have withdrawn up to that point.

To avoid mistakes, it’s ideal to set up a separate IRA so you can isolate the money to meet the 72(t) payments from the rest of your retirement assets.

Once 72(t) payments begin, you must receive payouts for five years or until you turn 591⁄2, whichever is longer. For example, if you start taking 72(t) payments at age 50, you must continue to receive those payments until you are 591⁄2, a total of nine and a half years.

While all the payments will be free from the penalty, you will still owe ordinary income tax on the traditional IRA distributions.

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