How to raid your nest egg without penalties

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Q. I turn 55 in 2017 and will be separated from my job because of outsourcing. I’ve learned I may be able to take withdrawals from my 401(k) without an early withdrawal penalty. Would I be able to delay my 401(k) withdrawals until 2018 and still avoid any early withdrawal penalty?
— Retired earlier than planned

A. The exception to the 10 percent early withdrawal penalty at age 55 is a tricky one.

To be eligible, the separation from service must occur in or after the year you turn 55.

Using your situation as an example, if you already had separated from service prior to reaching age 55, you would not be able to avoid the penalty even if you waited until after age 55 to take the distribution, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

However, if you separate from service in 2017 — which is the year you turn 55 — then you can avoid the penalty even if you don’t begin withdrawing funds from the 401(k) plan until 2018, Hook said.

He said if you did separate prior to age 55, you still may be able to avoid the early withdrawal penalty.

You can roll the 401(k) plan balance tax-free to an IRA account, and once the funds are in the IRA, you can use a provision called 72(t). This allows you to set up distributions from the IRA, and if the distributions are considered to be a series of “substantially equal periodic payments” over your life expectancy or the life expectancies of you and your designated beneficiary, you’ll avoid the 10 percent early withdrawal penalty, Hook said.

Substantially equal periodic payments do not have to be equal to qualify. There are three methods to make the calculation:

RMD Method: Distributions are taken each year by dividing the prior year’s ending balance by the number from one of the IRS life expectancy tables, Hook said. Using this method will result in a different amount each year.

Fixed Amortization Method: Distributions are fixed each year and the amount is calculated using the account balance, the number of payments from the IRS life expectancy tables and an interest rate, Hook said. The taxpayer can choose an interest rate as long as it does not exceed 120 percent of the Federal Mid-Term Rate for either of the two months immediately preceding the month in which the payments are to begin.

Fixed Annuitization Method: Distributions are fixed each year, calculated using the account balance, the an annuity factor from mortality table provided in IRS Rev Ruling 2002-62 and an interest rate, Hook said. Again, the taxpayer can choose an interest rate as long as it does not exceed 120 percent of the Federal Mid-Term Rate for either of the two months immediately preceding the month in which the payments are to begin.

“Regardless of which method is used, even though the payments are calculated to be taken over a long period of time, the taxpayer can stop or alter the payments if they have reached age 59 ½ and have taken at least five years’ worth of payments,” Hook said.

If the taxpayer modifies or stops the payments before five years and reaching age 59 ½, the 10 percent early withdrawal penalty is applied to all the previous distributions, he said.

Depending upon the size of the distributions, this amount can be quite high.

These rules are complicated and if not you’re not careful, you may wind up being out of compliance and the penalties will be applied. Be sure to consult with an advisor who understands the rules.

Email your questions to moc.p1563265025leHye1563265025noMJN1563265025@ksA1563265025.

This post was first published in January 2017.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.