Category Archives: Tax Planning

Retiring Early: One way to avoid the 10% early withdrawal penalty tax

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You might have heard that you need to keep your money in your retirement accounts until you are 59½ in order to avoid the 10% early withdrawal penalty tax, but did you know that if your money is in a work retirement plan, like a 401(k), that the you can take it out earlier and still avoid the penalty?

Exception to the rule

To quote directly from the IRS website explaining this exception to the 10% early withdrawal penalty tax:

“Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50”

55 and separation from service

If you wait until the year you turn 55, then leave your employer, you can take money out of your 401(k) or 403(b) without the 10% early withdrawal penalty tax.  You will still pay income taxes of course; Uncle Sam wants that part of your retirement account.  And be careful, depending on the other income you have, the amount of income taxes you owe could be even more than has been withheld, so be sure to calculate quarterly estimated taxes so that you are not caught by surprise.

If you roll your 401(k) over to an IRA rollover account, you lose this “age 55 separation from service” exception, because it only pertains to employer plans, not IRA rollovers.

50 if you are a fireman or policeman

If you are a qualified public safety employee of the state or local government, such as a police or fireman, the age is even lower – 50 years old.

Retire early?

In general most folks need to work and continue saving their money until their mid to late 60s so that they can save enough to retire.  But for those that have been strong savers and have learned to live well beneath their means, an early retirement is a possibility.

For a lot of folks who retire as early as 55, they have resources besides retirement accounts that they tap into, for example; from the sale of a business or money they have put into regular brokerage accounts over the years after they put the maximum contributions into their retirement accounts.  If you don’t have money in non-retirement accounts that can get you through to age 59 ½, then the “age 55 separation from service” exception might be the solution for you.

Run the numbers

Only in a few situations would it make sense to tap into the retirement accounts as early as 55 years old.  One situation that comes to mind, is in the case of someone who has maxed out their contributions in their work plan since the time they started working, and they have a balance in their current employer’s retirement plan that is large enough to live off of for a four or more years.  They have run the numbers and have enough retirement assets to live off of, however they do not have enough in non-retirement accounts to live off of until they turn 59 ½, perhaps due to putting kids through college or paying off the mortgage.

Really check your numbers to make sure that you can afford to retire at 55, taking the impact of inflation into account.  Inflation has a significant impact on retirement planning.  Consider that starting to spend down your portfolio at such a young age, when you could easily live another 35 or 45 more years could jeopardize your financial future.   However, if once you have done the analysis you can afford to retire early, then you deserve to enjoy what you have worked so hard for and this “age 55 separation from service” exception to the 10% early withdrawal penalty tax is one way to help you do that.   

Annuity Questions Answered

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So many new clients come to me already owning an annuity or several annuites, and they do not understand them or know what types of fees are in them.  I went back through my e-mails to clients and looked through the types of questions I get about annuities and thought I would answer some of them here by explaining some of the concepts around annuities.

An annuity is a product offered through insurance companies.  It is tax deferred, which means the income and earnings from the investment stay in the account and are not reported on your tax return each year.  That is the good news.  The bad news is that when you take the money out of the account, it is taxed at your income tax rate, which could actually be at a higher rate than the rate you would have paid if you hadn’t had your money invested in an annuity, depending on the type of annuity you have.  However, the tax deferral is a nice benefit.

Fixed Annuity

With a fixed annuity you get a specific interest rate for a specific time period.  Sometimes you will get a higher rate for the first year and then a lower rate for the remaining years, but you know this when you make your initial purchase.

Variable Annuity

A variable annuity offers you the opportunity to invest in mutual funds.  There are annuities that invest in multiple fund families, including index fund families.

Death Benefit

This is an insurance product, so one feature, or “insurance rider” that some of these products have is something called a Death Benefit.  Sometimes the Death Benefit value can be more than the Account Value.  Each product’s Death Benefit works differently.  Sometimes it is as simple as saying the Death Benefit is the greater of current market value or what you invest minus withdrawls.  Or it might have a Step Up feature.  For example each year on the anniversary of the purchase date the value is recorded and the highest annual value or current market value is the Death Benefit if you pass away.

1035 exchange

One nice benefit to this type of product is that you are allowed to move from one insurance company to another without any tax consequences.  Doing this is called a 1035 exchange (that is the IRS name for the procedure of moving the money, it seems like they put code numbers in the names of all of their procedures).  If you cashed the money in you would have to pay taxes on the gains.  If you just move it to another annuity, then you can continue to defer the taxes.

Fees

When looking at annuities be sure to compare fees.  Fees are quoted in percentages.  It is extremely important to convert the percentages to actual dollars based on the amount you are investing because when you do that you can sometimes see thousands of dollars of difference in fees between two annuities that when just looking at percentages seem to be pretty similar in fee structure.  I would always rather see my clients with that money in their account rather than give it to an insurance company unnecessarily.

Surrender charges

A surrender charge is a fee you pay the insurance company if you take your money out in the first few years after you have had the annuity.  A seven year surrender charge schedule is very common, for example the first year surrender charge would be 6%, the second year would be 5%, and so on until the surrender charge went away.  You might be surprised to know that there are annuities that do not have surrender charges!  So if you have an annuity and you are in the position of having to decide what to do with it, you can 1035 exchange it to an annuity that does not have a surrender charge.  Most people are not aware of that.

IRA annuity

If you have an annuity that is an IRA, you can always move it directly to an IRA, and forgo the extra layer of fees that you find in an annuity.  Things to consider before doing that: 1) are there surrender charges? 2) is the death benefit greater than the current value of the account?

Learn more about your annuity by reading the statement and the prospectus.  If you don’t have the prospectus, many of them can be found online by Googleing the product name.  If that does not work, give the customer service department a call, they will be happy to e-mail or mail you a copy of the prospectus which has the fee and investment information.