(FiveNation.com)- One approach to avoid the 10% early withdrawal penalty from your IRA or 401(k) is to make substantially equal periodic payments, and fixed annuities can be a vital part of this early retirement income plan.
Following the pandemic, more people are looking to tap into their retirement accounts to retire early. They can now take larger early withdrawals without incurring tax penalties, thanks to an IRS regulation that took effect in January 2022.
This is how it goes.
If you withdraw money from your IRA, 401(k), SEP IRA, or other qualifying plans before the age of 59 1/2, you will be subject to a 10% tax penalty. If you make “substantially equivalent periodic payments” (SEPP, also known as the 72(t) exemption) or qualify for another more limited exception, the penalty is waived. The payments must be made for five years or until you reach the age of 59 1/2, whichever comes first.
Withdrawals utilizing fixed amortization, one of the most generous SEPP options, were formerly based on your life expectancy plus a modest monthly interest rate (most recently 2.07 percent -2.09 percent, depending on payment frequency). It was difficult to plan because this rate was a shifting objective.
IN JANUARY, the IRS established the basic interest rate as “any interest rate not exceeding 5%.” That implies you can borrow more money without incurring penalties and have greater certainty.
You’ll need a plan that will generate consistent income. Dividend-paying stocks and bonds are an option, but the income may fluctuate, and you may have to dip into your principal if the market falls.
However, subject to the annuity policy requirements, a fixed-rate annuity can provide guaranteed interest income and access to principal. It’s similar to a bank certificate of deposit in that it’s underwritten by life insurers and pays a fixed rate of interest for a specific period.
On the other hand, fixed annuities often pay greater rates than CDs with the same period and provide more penalty-free liquidity.
Consider the following scenario. Pete, who is 50 years old, decides to retire early. In his IRA and 401(k) plans, he has $1.6 million. He wants to take $50,000 out of his account each year. He sets up $1 million for his SEPP with fixed amortization. He could draw essentially equal monthly payments of up to $60,312 a year from that $1 million — the most he could take, depending on his life expectancy and the IRS-defined 5% base interest rate. However, because that sum exceeds his income demands and would leave him with less principle after ten years, Pete chooses a more conservative lower amount.
He purchases a $1 million 10-year fixed annuity with a 3.5 percent annual interest rate from an AM Best-rated provider. Even though the annuity pays less than $50,000 in interest per year, he will earn $50,000 yearly since the IRA annuity he picks allows for penalty-free withdrawals of up to 10% of the account balance each year. As a result, the $50,000 yearly payments that Pete decides to make at the start of each contract year are readily accommodated.