Dreaming of early retirement?
You’re not alone. It’s becoming more and more common for American workers to access their retirement funds earlier than the IRA withdrawal age of 59 ½. In fact, a recent TD Ameritrade survey found that a jaw-dropping 46% of Americans aged 40 to 49 have taken money out of a retirement plan.
It’s not always by choice, and early retirement distributions usually have financial penalties. Still, according to the same survey, 50% of people retired early due to reasons beyond their control, such as layoffs, caregiving responsibilities, or an unexpected shift in their health, job, or financial situation.
Whether you choose or circumstances force you into choosing, retirement before age 59 ½ can create income challenges. For example, you are not yet eligible to receive retirement benefits from Social Security, and you may or may not have a monthly pension to generate income.
Fortunately, there are some steps you can take to optimize your tax planning strategy and get the most out of your early retirement distribution.
Read on to learn about early retirement distributions, how a SEPP plan can help you avoid penalties, and how to make your withdrawals more tax-efficient.
An early or “premature” retirement distribution is a withdrawal of funds from your retirement account before the designated age at which there are no penalties on withdrawal (59 ½ in the case of an IRA). In most cases, you must pay taxes on early retirement distributions. Additionally, the rules for how and when you may make an early withdrawal can vary.
In many situations, you will need to generate income from your assets. Often, most of your assets are in a retirement plan through a 401(k) plan at your employer or in an individual retirement arrangement (IRA). Withdrawals of earnings and pre-tax contributions are subject to ordinary income tax. In addition, you may be subject to the 10% early withdrawal penalty tax on distributions taken before you reach age 59 ½.
One strategy to generate income from retirement accounts if you are under 59 ½ years old is to take periodic distributions from those accounts. If you structure your distributions properly, you can avoid the 10% additional tax on your withdrawals. You can take distributions from various retirement accounts such as 401(k) plans, 403(b) plans, and IRAs.
A Substantially Equal Periodic Payment (SEPP) plan is a little-known program that allows you to take withdrawals from retirement accounts without incurring the 10% penalty through specified annual distributions over a period of five years or until you turn 59 ½, whichever comes later. However, one caveat is that you will still owe income tax on the withdrawals.
You can set up a SEPP plan with any qualified retirement account except a 401(k) you hold at your current employer. However, there are some very specific rules you’ll need to follow:
For example, if you establish a SEPP from your IRA at age 52, you must continue to take withdrawals until you reach 59 ½. If you discontinue or change your SEPP withdrawals before you reach that age, the current year withdrawal is subject to the additional 10% tax unless an exception applies. In addition, the SEPP withdrawals for previous years are retroactively subject to the 10% tax.
If, however, you begin SEPP withdrawals at age 58, you must continue the withdrawals to age 63 to comply with the 5-year withdrawal requirement.
To be “substantially equal periodic payments,” your payments need to meet the standards of one of the three calculation methods allowed:
If you begin distributions in a year using either the amortization method or the annuitization method, you may in any subsequent year switch to the required minimum distribution method to determine the payment for the year of the switch and all subsequent years. The change in method will not be treated as a modification.
Once you make the change, you must follow the required minimum distribution method in all subsequent years until you meet the required number of years under the plan. You may not take any other contributions or distributions from the account from which you are taking distributions during the SEPP period.
If, as a result of following an accepted method of determining SEPP withdrawals, your IRA assets are exhausted, you will not be subject to the additional income tax of 10%. The resulting cessation of payments will not be treated as a modification of the series of payments.
A SEPP plan can be a beneficial tool for those who need to access retirement funds early. However, there are also some direct drawbacks to this approach.
For example, the rules for distributions using the Internal Revenue Code provide very little flexibility. Once the distribution begins, you must exert extreme caution in making any changes to the distribution amount and frequency.
Furthermore, it would help if you documented the calculations used to determine the distribution and any change in distribution. Tax courts have consistently assessed the 10% additional tax for taxpayers who could not substantiate the distributions were, in fact, based on SEPP calculations.
If you plan to retire early, it’s essential to consider the tax consequences associated with taking an early retirement distribution. It is always a good idea to consult with a tax professional to make the process as tax-efficient as possible.
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
His business experience includes:
Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.
Jeff also has a long history of helping individuals manage their taxes and plan their finances including:
Income tax planning and strategy.
Filing quarterly and annual taxes.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
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