By Christian Patterson, CFP®, Wealth Advisor
Retirement planning is a journey, and as with any journey, it is crucial to map out your route. When it comes to retirement accounts like 401(k)s and IRAs, one key aspect of this journey is understanding distribution strategies. How you withdraw money from these accounts can significantly impact your financial future. In this guide, we will explore distribution strategies before and after age 59 ½ as well as essential considerations for both scenarios to help you Spend Life Wisely.
If you are interested, you can find our past article about 401(k) contributions here.
Distribution Strategies Prior to Age 59 ½
Before you reach the age of 59 ½, withdrawing funds from your 401(k) or IRA can be a bit tricky. Normally, early withdrawals come with a hefty penalty of 10% on top of the regular income tax. This can really diminish the value of the money you have worked so hard to save. However, there are a few strategies available to you that can help protect your nest egg and avoid paying more than necessary to Uncle Sam.
- The Rule of 55
One valuable option available to those leaving their job at age 55 or later is the Rule of 55. This rule applies only to 401(k) plans, not IRAs. Under the Rule of 55, if you leave your job at age 55 or older, you can withdraw funds from your 401(k) without incurring the 10% early withdrawal penalty, even if you are not yet 59 ½. This provides a window of flexibility for early retirees who want to access their retirement savings. There are several things to keep in mind to avoid running afoul of the IRS:
- You must have left your job in the calendar year in which you turn 55 to be eligible for the penalty free distributions.
- Withdrawals can only be made from the plan specific to the employer you are separating from and not any of your other IRAs or previous employer sponsored plans. Withdrawals from other accounts will still incur penalties.
- The account balance must remain in the 401(k) plan to continue receiving penalty free withdrawals. Once you reach age 59 ½, and are no longer subject to early withdrawal penalties, you can roll the account balance into an IRA if you choose.
- Roth IRA Withdrawals
Another strategy for making retirement account withdrawals prior to age 59 ½ is tapping into your Roth IRA contributions. Unlike traditional IRAs and 401(k)s, Roth IRAs allow you to withdraw your contributions at any time, tax and penalty-free. Keep in mind that this rule applies only to the contributions you have made, not the earnings on those contributions.
If early retirement is a goal you have, it may be worth discussing a Roth IRA conversion ladder to plan out penalty free retirement account withdrawals prior to age 59 ½. This should be discussed with your financial advisor to ensure the ladder is in alignment with your overall financial strategy and to ensure your plan is compliant with IRS regulations and guidelines.
- The Substantially Equal Periodic Payments (SEPP) Rule
The final strategy we are discussing will be the most complex of them all. The IRS provides a way to avoid early withdrawal penalties with the Substantially Equal Periodic Payments (SEPP) rule. Under SEPP, you can take substantially equal payments from your retirement account without incurring the early withdrawal penalty. These payments must follow an IRS-approved calculation method and continue for at least five years or until you reach 59 ½, whichever is longer.
The three methods are (1) the amortization method, (2) the life expectancy method, and (3) the annuitization method.
Amortization Method: this method determines an amount the amount that can be withdrawn from an account by amortizing the balance of the retirement account over their single or joint life expectancy. This method generally results in the largest amount an individual can withdraw, and that amount will be fixed for the duration of the SEPP.
Life Expectancy Method: this method is sometimes referred to as the “minimum distribution” method and, as you might guess, generally results in the smallest possible withdrawal amount. This method takes the life expectancy factor from either the single or joint life expectancy tables provided by the IRS to divide the retirement account’s balance. Due to the way this is calculated, the withdrawal amount is adjusted annually as the account balance changes.
Annuitization Method: this method is calculated using an IRS provided annuity factor to determine the equivalent payments allowed to be withdrawn penalty free from the retirement account. This calculation will generally fall in the middle of the amounts calculated by the amortization method and life expectancy method. As with the amortization method, the withdrawal amount is fixed and will not change from year to year.
It is important to remember that if somebody is taking withdrawals via the SEPP rule there may be penalties involved with prematurely ending the payments or adjusting them. However, the IRS does allow a one-time change from the amortization or annuitization method into the life expectancy method without penalty. This will typically be used in cases where there is a significant drawdown of the account so the distribution requirement is lowered thus allowing the remaining account balance to last longer.
This strategy is available in both Individual Retirement Accounts (IRAs) and employee sponsored plans such as a 401(k) or 403(b).
Bankrate has a simple calculator if you are interested in seeing how much you may be able to withdraw from your retirement accounts using SEPP. The calculator can be found here.
Substantially Equal Periodic Payments will likely be the most complex way to access your retirement accounts prior to age 59 ½. In many cases, the other two strategies discussed earlier in this article will be much simpler to implement. As always, it is recommend to consult your financial advisor to determine what options may be best for your specific circumstances.
Distribution Considerations After Age 59 ½
- No Penalty for Early Withdrawals
Once you reach age 59 ½, the 10% early withdrawal penalty disappears. You can access your retirement accounts without worrying about this additional tax, making it a good time to consider more flexible withdrawal strategies.
- Consider Your Tax Bracket
Evaluate your current and expected future tax brackets when deciding how much to withdraw. By strategically managing withdrawals in retirement, you can minimize your tax liability. This might include taking advantage of lower tax brackets in early retirement or spreading out withdrawals to avoid bumping up into higher tax brackets later on.
- Required Minimum Distributions (RMDs)
You must begin taking Required Minimum Distributions (RMDs) from traditional IRAs and 401(k)s once you reach a certain age (see table below). These distributions are subject to income tax and failure to take them can result in substantial penalties. Plan ahead for RMDs to avoid unexpected tax hits.
Date of Birth
June 30, 1949 or earlier
July 1, 1949 - December 31, 1950
January 1, 1951 - December 31, 1959
January 1, 1960 or later
- Diversify Your Tax Liability
Consider diversifying your retirement savings to manage future tax liability effectively. Balancing traditional pre-tax accounts (like 401(k)s and traditional IRAs) with post-tax accounts (like Roth IRAs or brokerage accounts) can provide tax flexibility in retirement. You can choose which accounts to draw from based on your tax situation.
- Seek Professional Guidance
The world of retirement account distributions can be complex, with significant tax implications that are ever changing. It is highly advisable to consult a qualified financial advisor or tax professional who can tailor a distribution strategy to your unique circumstances.
Understanding 401(k) and IRA distribution strategies is pivotal to securing your financial future. Whether you are considering withdrawals before or after age 59 ½, or just looking to optimize your overall retirement plan, careful planning and professional advice from an Exencial advisor can make a substantial difference in your financial well-being during retirement. Start planning today so you can Spend Life Wisely tomorrow.
Disclaimer: The information provided in this article, including Bankrate’s SEPP calculator for 72(t) distributions, is for educational purposes only and should not be considered as financial or legal advice. Please consult with your financial and tax advisors to determine the suitability of withdrawals pursuant to the Rule of 55, ROTH IRA contributions, and Substantially Equal Periodic Payments for your individual circumstances.
The Bankrate SEPP calculator for 72(t) distributions defaults to a “reasonable interest rate” that is lower than current market rates and should be adjusted higher.
Exencial Wealth Advisors is an SEC-registered investment adviser. Any references to the terms “registered investment adviser” or “registered,” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.