When it comes to your retirement account, what you hear mostly is the importance of saving early and taking advantage of tax shelters. But what if you want to retire early? What can drag out is the annoying IRS 10% penalty for early withdrawal. There are a few ways to get around that penalty, like disability or death and it’s possible to take out a loan from your Solo 401k. However, those probably aren’t the answers if you’re in your 40s or early 50s and need to get to 59 ½.
The early retirement answer you are looking for might be in IRS Tax Code Section 72(t).
IRS Tax Code Section 72(t)
If you are interested in early retirement, IRS Tax Code Section 72(t) might be for you. It is called the Substantially Equal Periodic Payments rule (SEPPs). According to rule 72(t), you can withdrawal from your Solo 401k or other qualified retirement accounts and IRAs without a penalty. But only IF you take them in equal periodic payments.
Before you start planning that around-the-world trip you’ve been dying to take, there are sections of 72(t) that have to be met for the exception of the 10% early withdrawal penalty tax. Rule 72(t) opens a lot of doors, but with limitations. One limitation is that you can’t take the around-the-world trip and then stop making payments once you return home. Once you begin taking SEPPs, you have to continue to pay for 5 years or until you turn 59 ½ – whichever is later. There are also only three ways that your equal periodic payments can be calculated. If you don’t follow the rules for early withdrawals, you’ll owe the 10% penalty PLUS back interest. Reinstating the penalty and back interest also happens if you make mistakes when calculating your withdrawals.
You want to know your SEPP payment options and calculate the amount you can receive.
Three Ways to Calculate Equal Periodic Payments
You have three options for calculating your SEPPs and each is significantly different. The three allowed methods are:
- Amortization method
- Minimum distribution (or the life expectancy method)
- Annuitization method
These calculations are not simple to do but you do want to understand each before making your decision. All three methods require using the life expectancy table. The first and third methods (amortization and annuitization) also require you to use a realistic interest rate. Making the right decision the first time can be important because IRS Rev. Rul. 2002-62 only allows a one-time change from either the amortization method or the annuitization method. If a change is made under this rule, the minimum distribution will be the same for subsequent years. Otherwise, you’re almost certain to owe 10% penalty plus interest.
As the word ‘amortization’ implies, you might think of this like a real estate mortgage amortization schedule. The big difference is that you are working your Solo 401k funds down to zero and the payment schedule is over your life expectancy. The IRS allows you to choose from one of the three life expectancy tables to determine the timeline:
- Single Life Expectancy
- Uniform Life Expectancy
- Joint Life and Last Survivor Expectancy
Like real estate mortgage, you will need an interest rate to determine your payments. The IRS lets you use your judgment as long as the rate doesn’t go over 120% of the federal mid-term rate from either of the two months preceding the month you start distributions. (Note: the interest rate changes monthly).
The IRS offers the following example for calculating the payment using the amortization method:
The annual distribution amount is calculated by amortizing an example account balance of $400,000 over an example single life expectancy of 34.2 years at a 2.98% interest rate (current age is 50). The annual distribution amount is $18,811.
Partial distributions can be taken monthly to equal the annual amount.
This is considered the easiest to calculate but can also have some drawbacks. One drawback is that it has the lowest annual distribution. It also has to be recalculated each year. Luckily, it does not require calculating an interest rate.
The minimum distribution method divides your account balance every year by your life expectancy. The annual recalculation requires looking up your life expectancy in the IRS tables each year. Fortunately, that calculation is straightforward. Some people who expect their account balance to fluctuate a lot from year to year prefer this method.
Using the same IRS example, an example distribution looks like this:
The account balance of $400,000 is divided by the single life expectancy of 34.2 years.
Based on age 50 ($400,000/34.2) it equals an annual distribution of $11,696.
The annual distribution amount is calculated by dividing the account balance as of December 31st of the prior year by the single life expectancy. It uses the same single life expectancy table from the prior year but changes to the current age. The life expectancy decreases each year so it is always the denominator. The distribution will increase every year if the account continues to grow.
This is probably the most difficult method to calculate. It resembles what insurance companies use to determine annuity or pension payouts. Still, it is like the amortization method because you’ll take equal annual distributions.
This method consists of the account balance, an annuity factor, and an annual payment. The annuity factor is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and an interest rate of not more than 120% of the federal mid-term rate. The IRS explains the annuity factor you’ll use as “the present value of an annuity of $1 per year for the life expectancy of the account holder.”
You are going to need to create a formula in a spreadsheet or use a financial calculator. The basic formula in an Excel spreadsheet would be: =PV(Rate, Number of Periods, Payment, Future Value, Type).
A Brief Comparison of the Options
Both the amortization and annuitization have a fixed annual payouts. The amount will remain the same for 5 years or until you reach the age of 59 1/2 (whichever is later). However, you can make a one-time switch to the minimum distribution payout method.
Typically, the amortization method and annuity payout method will have similar distribution amounts. The minimum distribution method will be lower in the beginning because it does not earn interest.
Ultimately IRS Tax Code Section 72(t) might allow you to retire early without paying the 10% early withdrawal penalty.
Consult your financial advisor or estate planning professional.