Unfortunately, in light of the weak job market and other economic pressures, many Americans are raiding their 401(k) plans to meet their financial needs. For those under 59 ½, withdrawals made from these accounts (in contrast loans from them, which have their own rules) usually means paying income taxes and a 10% penalty on the amount withdrawn.
While most 401(k) withdrawals before age 59 1/2 are subject to income taxes, it sometimes is possible to avoid the 10% penalty by taking advantage of the substantially equal payment rule. This process is not for everyone, but it can be useful for some individuals, especially those who are within about five years of age 59 ½. Here’s how it works.
First, determine how much you can take out each year. You must make substantially equal payments based on your remaining life expectancy or the joint remaining life expectancy of you and your account’s designated beneficiary. For example, if you are a 55-year-old male, your remaining life expectancy would be about 25 years, so you must calculate substantially equal payments based on your account balance and an expected 25-year term.
There are a number of acceptable methods of calculating the withdrawals, and they may result in significantly different withdrawal amounts. Therefore, it can pay to evaluate several accepted methods so that you choose the one that will result in payments most beneficial to you. Some methods take into account an expected rate of return on the projected balance in the account over your remaining life expectancy. Be sure to use a reasonable rate that you can defend if necessary.
Keep records of how you calculated your substantially equal withdrawal amount in case the IRS requests this information in the future. It is important to be able to justify the amount you withdraw each year because, if the IRS disagrees with your calculation, you could be slapped with a penalty.
Second, decide how you want to withdraw the money each year. For example, you could take a lump sum each year or you could choose monthly withdrawals.
Third, arrange with the financial firm where you have your 401(k) account to set up the withdrawals. You probably will want the payments automatically deposited in another account, either at the same or another financial firm.
Fourth, realize that you must take annual substantially equal payments for at least five years or until you reach age 59 ½, whichever is longer. Once withdrawals have been made for at least five years and the account owner is at least 59 ½, the amount withdrawn each year can be adjusted (or eliminated) penalty-free. This is one reason taking substantially equal payments often is a better option for those close to age 59 ½ than much younger individuals.
Because the financial penalty for breaking the 401(k) withdrawal rules can be steep, it is a good idea to talk to your financial advisor before setting up a withdrawal plan. He or she can advise you about the pros and cons of taking money out of your 401(K), based on your specific financial situation, and, if you decide on substantially equal withdrawals, can help you set up your payment plan so that it meets all the rules.
www.ehow.com, How to Retire Early on a 401k With No Penalty – eHow.com
Barry C. Picker, CPA/PFS, CFP, www.bpickercpa.com, Annuitizing an IRA