More and more people are planning to retire before reaching age 60. One issue they
face is the possibility of paying 10% penalties on early distributions from 401(K) plans,
403(B) plans and IRAs (Hereafter we’ll use 401(K) for both 401(K) and 403(B) plans). In
general, retirement distributions before age 59 and ½ from these plans trigger a 10%
tax penalty.
We typically advise clients to utilize their taxable investment accounts first to fund
retirement income needs not met by pensions and Social Security payments. Doing so
allows those account to continue to grow tax free. Those who retire early, however,
often must tap retirement accounts in order to make ends meet. In some cases the bulk
of a clients’ savings is in 401(K) plans and IRA accounts. They often are vested in
pension plans that severely reduce payments started before age 65.
Many people are unaware that there are ways to take distributions early, without
penalty. First, you should be aware that you can withdraw funds from your 401(K)
before age 59 and ½ without the 10% penalty if you separated from your employer after
age 55. This only applies to the 401(K) plan you had with the employer from which you
separated and does not apply to IRAs. Plans from other employers you separated from
before reaching age 55 would carry a 10% penalty for pre-59 and ½ withdrawals.
If you change employers before age 55, plan to retire early and expect that you’ll have
to draw funds from your 401(K) plan to get by, you should investigate the possibility or
rolling the 401(K) plan from your previous employer to your new employer’s plan. Those
funds would then be available to you without penalty when you leave the new employer
after reaching age 55.
It is also possible to withdraw funds from IRA accounts without the 10% penalty before
reaching age 59 and ½. Distributions allowed without penalty are called substantially
equal periodic payments (SEPP), also called 72(t) distributions after the tax code section
that authorizes them. Once initiated, they must continue for 5 years or until age 59 and
½, whichever is later. The payments cannot be changed once they begin. If the rules
are not followed carefully, distributions may be subject to a 50% penalty.
The rules for 72(t) distributions are rather complex, so if you plan to utilize them you
would be well advised to seek the advice or a qualified financial planner or accountant.
We will cover the features of 72(t) distributions in greater detail in a future article.
Note that there are other special situations in which you can withdraw funds from a 401
(K) or an IRA without the 10% penalty. These include distributions related to a disability
or death, for medical expenses in excess of 7.5% of Adjusted Gross Income and some
other special cases. None of these special cases, however, would be appropriate for
funding an early retirement.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, December, 2007
So You Want to retire Before 59 and 1/2
By David and Erin Patterson