Early Withdrawal and Annuity Purchase are Possible without Penalty from Tax-Deferred Accounts

Although it may appear counter-intuitive, and disagreement may abound from plan sponsors and financial advisors, you can tap into your IRA and other tax-deferred accounts early without paying a penalty.

You have a great deal of latitude when deciding how much money to take out of the account each year. Even better, after you've met your short-term cash needs, you can stop making withdrawals and get the account's tax-deferred compounding working in your favor again. (Ed. note: That is, the withdrawals can stop after the later of age 59½ or having taken at least 5 annual payments.)

Normally, when you take a distribution from an IRA, if you are not at least age 59½, you must pay a penalty tax: 10% of the amount of the withdrawal. This is in addition to the income taxes that are due. To avoid this penalty, you effectively convert the account into an annuity, and take what the IRS calls "a series of substantial and equal periodic withdrawals."

The distributions must be made at least annually, and must be computed using an IRS-approved method. You can use reasonable mortality tables to determine these numbers. You also are allowed to use a reasonable interest for the calculations. The flexibility on interest rates and life expectancies gives you leeway in determining the amount of your distribution.

The following are three methods specifically approved by the IRS. Keep in mind that each gives a very different result.

Straight life expectancy method:

Locate you life expectancy in IRS tables and divide that into the IRA account balance. The result is your annual distribution. This figure can be recalculated each year if you so choose.

Amortization method:

This strategy is similar to computing the payment on a mortgage. Take a reasonable life expectancy and interest rate, and use either a financial calculator or amortization table to compute the annual distribution. Some advisors believe you can effectively treat this as an adjustable rate mortgage, changing the interest rate and amortization period each year. But the IRS has not yet taken a position on this.

Annuity method:

Determine a reasonable interest rate and life expectancy. Then use these and the payment factor from a standard annuity table to determine the annual payment. Under this method you do not change the annual payment once it is computed.

You can change the distributions even further by using different interest rates and life expectancies, as long as the figures are reasonable. The IRS says you can use any reasonable method to compute the distributions, but it doesn't give any guidance as to what other methods count as "reasonable.

"The IRS rules for avoiding the 10% early withdrawal penalty can be complicated. If you are interested in tapping your tax-deferred account early while avoiding the penalty, consult a tax or financial advisor who will lay out all your options and choose the best method for you.

[Reprinted with permission of Tax-Wise Money, Feb. 12, 1996. Agora Financial Publishing, 824 E. Baltimore St., Baltimore, MD 21202. Subscriptions: 800-433-1528, $39/yr.]