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News Briefs
IRA option can topple retirement
Law lets you tap in early, but rules are tricky
11:53 PM CDT on Sunday, June 11, 2006
By WILL DEENER / The Dallas Morning News
The federal government, in its wisdom, doesn't want us to spend all our retirement money too quickly. So the tax man charges a 10 percent penalty to discourage anyone from tapping into their Individual Retirement Account before age 59 ½.
There is a way around it, though.
Section 72(t) of the Internal Revenue Code allows people to withdraw money from their IRA penalty-free before age 59 ½ , provided the withdrawals are in "substantially equal periodic payments" for at least five years.
Sounds simple enough, but it's not. And an increasing number of early retirees are being whipsawed by the temptation and the complex rules that come with it.
"This section is creating a lot of havoc for early retirees," said Mark McClanahan, a certified financial planner at Baker Financial Services in Arlington.
"I see this almost every day because there have been a lot of company buyouts in recent years.
"And people are retiring early, but they just don't understand this law."
Richard Lewins, a Dallas lawyer with the firm of Burg Simpson, said the basic problem is that brokers and investment advisers talk retirees into unrealistically high withdrawals from their IRA accounts.
"They tell people the market returns an average of 10 percent a year, and we will only take out 8 percent, so your money will continue to grow," Mr. Lewins said. "Well, the reality is that the market doesn't produce consistent returns. It can and often does decline, sometimes for years."
When this happens, it results in big chunks of cash being pulled from the retirement account and a quick depletion of the principal - not what most retirees bargained for.
When Carl Hendrik retired early in 2000, he used the 72(t) section to dip into his IRA.
Mr. Hendrik, then 56 years old, had worked for Texas Instruments Inc. in Sherman for 35 years and had amassed a plump nest egg of more than $700,000. As a parts inspector, he earned a modest salary of about $45,000 a year, but each year the company awarded employees company stock for their retirement accounts.
His IRA, which was invested almost exclusively in TI stock, had soared in value during the technology romp of the late 1990s and actually doubled from 1998 to 2000. He contacted a stockbroker who assured him that he could withdraw $60,000 a year in "substantially equal periodic payments" without touching the principal. That was based on the assumption that the account would earn 7.5 percent annually.
"I was happy with that, because I was going to make more per year in retirement than I had working," Mr. Hendrik said. "I was going to get a pay raise just to retire."
Big mistakes
Mr. Hendrik and his Edward Jones stockbroker made two big mistakes. First - investing the bulk of his savings in one stock. Texas Instrument investors learned the same, sad lesson that Enron investors learned: Stock prices can collapse. TI shares dropped from above $90 to about $15.
Second mistake - assuming his stock investments would earn 7.5 percent a year. While it's true that the market returns an average of 10 percent a year, it's also true that the market can and often does drop.
If brokers promise anything over the return of a bank certificate of deposit, then they should also explain to their clients that they have to take on more risk to get it, Mr. Lewins said.
"If a broker said, 'I can get you 4 percent with no risk to your principal, or 7.5 percent but we are going to put a portion of your portfolio at risk,' most retirees would say never mind and take the 4 percent," he said. "Many times they are not given that option."
From the time Mr. Hendrik retired in July 2000 until he closed the Edward Jones account in August 2003, the losses and withdrawals totaled $380,000 - more than half the value of the account.
"My wife kept telling me I should do something, but I just let my broker tend to it," Mr. Hendrik said. "He was supposedly the expert. I didn't know anything about it."
Eventually, he won an arbitration case against Edward Jones and received about $280,000. An Edward Jones representative declined to comment on the case.
Now, at age 61, Mr. Hendrik said he's waiting to turn 62 so he can begin drawing his Social Security benefit to help offset the decline of his savings. "I just didn't keep a close enough watch on my money," he said. "I thought if I hired a professional it would work out for me, and I wouldn't have to touch the principal."
Timing factor
Drawing down the principal during a market downturn is not the only problem that early retirees face under 72(t). Many people underestimate the number of years they are required to withdraw the equal payments.
For example, those who retire, say, at age 50 may mistakenly believe that they are only obligated to take out the equal payments for five years, or in this case to age 55. That's incorrect.
The rule states that it is the greater of five years or until 59 1/2. In this case, that means from age 50 to age 59 ½ , or almost 10 years that the retiree is locked in to those exact payments. In other words, they don't have complete control of this account for nearly 10 years.
Similarly, those who retire at, say, 58, might think they will have complete access to their IRA in a year and half. But in this case, they have to make the withdrawals at that set rate for five years, or until age 63. If they had not invoked 72(t) at age 58, then at age 59 ½ they could have withdrawn any amount without penalty.
And here's the real kicker. Let's say a retiree has been taking out $40,000 a year under 72(t) for three years. Then an unexpected expense comes along, and the retiree needs to dip into the account for an extra $10,000.
That's a violation of the "substantially equal payments" rule and subjects the retiree to the 10 percent penalty.
"And guess what? The IRS imposes that 10 percent penalty on all the money that was taken out over the past three years, not just the $10,000," Mr. McClanahan said. "That is nasty, and people don't realize it. And I see this happen every year."
In this case, that would be a penalty of $13,000 - 10 percent of $130,000.
Obviously, the best course of action for early retirees to avoid these pitfalls is to wait until at least age 591/2 to tap into their IRA. However, many people want to retire early, and they need their IRA money. "For so many people this is the only option they have," Mr. McClanahan said. "It's either take money from the IRA or they are not going to retire."
Additional savings
Ideally, early retirees should set aside some additional savings for unforeseen financial emergencies that are not locked in an IRA account. That way they won't have to "bust the IRA account," meaning violate the 72(t) rule and have to pay the penalty.
It's also OK to establish two IRA accounts, Mr. McClanahan said. For example, a retiree who received a lump-sum payment from his or her company of $600,000 could set up an IRA with $500,000 and a second IRA with $100,000.
The retiree could take the 72(t) payments from the largest IRA but not the smaller account. That way, unexpected withdrawals could be taken from the smaller account, resulting in a much lower penalty.
"That way they don't bust the big account and have to go back and pay taxes on all the money that was withdrawn," he said.
E-mail bdeener@dallasnews.com
How Rule 72(t) works
1. Section 72(t) of the Internal Revenue Code allows early retirees who withdraw money from their Individual Retirement Accounts before age 59 ½ to avoid the 10 percent penalty. Here's how it works:
The withdrawals must be taken in "substantially equal periodic payments."
The payments must be taken at least once a year for five years or until the retiree reaches 59 ½ - whichever is longer.
Violators of the "substantially equal periodic payments" rule are subject to the 10 percent penalty - and the penalty is assessed on the total amount of all the withdrawals.
Reprinted with the Permission of the Dallas Morning News
