Using Roth Accounts for Early Retirement
When individuals, either by choice or not, retire early, they may need to access funds from their IRA or 401(k) account. For those under the age of 59½, this could be a problem.
January 12, 2012
Normally, distributions prior to age 59½ are subject to an additional penalty tax of 10 percent unless an exception applies. One exception — applicable to 401(k)s but not to individual retirement accounts (IRAs) — allows distributions to a retiree who separates from service in or after the year they attain age 55.
Note that the age 55 exception only applies if separation from service occurs in or after the year the individual separates from service. If separation from service occurs at an earlier age, then the 401(k) cannot be accessed penalty tax-free until after age 59½.
Example: Robert and Roberta both retire in 2012. Robert was born in 1957 and Roberta was born in 1958. Robert can access his 401(k) immediately after retirement without the penalty tax, since he will be 55 in 2012. However, Roberta will have to wait until age 59½ to access her account without the penalty tax, unless she qualifies for different exception.
The Roth Factor
An individual who qualifies needs to make sure that they do not roll their 401(k) into an IRA. If they do so, they are then subject to the IRA rules and must wait until they attain age 59½, unless another exception applies.
Another exception to the penalty tax is for the individual to take distributions under a plan known as a Series of Substantially Equal Periodic Payments (SOSEPP). There are three acceptable methods for computing a SOSEPP:
Once a SOSEPP is started, it must continue until the later of five years from the first distribution or until age 59½. If there is an improper modification of the distribution amount during the period of the distributions under the SOSEPP, or if there is an improper transfer either into or out of the account, the 10-percent penalty tax will be imposed on all pre-59½ distributions, plus an additional tax equal to the interest would be due on all of the prior years' 10-percent penalty tax.
This is where a Roth account can be advantageous. Roth IRAs are advantageous based upon the ordering rules for distributions. In the case of Roth IRAs, amounts contributed can be withdrawn at any age, without any tax or penalty. In addition, any amount that was converted into a Roth IRA more than five tax years prior to the distribution year can be withdrawn at any age, without any tax or penalty. The only time the 10-percent penalty will apply in a Roth IRA is if the distribution occurs prior to age 59½, and is either from a conversion made less than six tax years prior or is from income.
This creates a planning opportunity for younger individuals, who can fund an "early retirement" fund by doing a series of Roth conversions so that the Roth IRA is properly "aged" at retirement.
A second way of having Roth funds for early retirement is through the use of a Roth 401(k) account. The Roth 401(k) distribution rules are different from the Roth IRA distribution rules. While the Roth IRA has distribution "tiers," the Roth 401(k) follows normal annuity distribution rules. That means that every Roth 401(k) distribution is part tax-free return the basis, and part income. That income is subject to taxes if under age 59½, and may be subject to the 10 percent penalty tax. This is why your clients should not take early retirement distributions from a Roth 401(k).
However, the planning opportunity is that upon separation of service, the Roth 401(k) can be rolled over into a Roth IRA. Once that is done, the Roth IRA distributions will follow the Roth IRA tier rules, meaning that the contributions to the Roth 401(k) — now considered as contributions of the Roth IRA — come out first.
Example: Andrea has contributed $100,000 to her Roth 401(k). It is now worth $125,000 and Andrea has separated from service at age 50. She wishes to take a $20,000 distribution. If she withdraws $20,000 from a Roth 401(k), 20 percent of that amount, or $4,000 will be subject to income tax and the additional 10 percent penalty tax. Instead, Andrea should roll her Roth 401(k) into a Roth IRA. Her $20,000 distribution would then be deemed to come from the $100,000 she contributed and will be tax and penalty free.
One last thought for using Roth accounts for early retirement distributions. Since the distributions are tax-free, individuals need smaller distributions to net the amount desired. This allows for more money to stay in the account and grow tax free.
For those planning or fearing early retirement, Roth accounts can be very useful tools.
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Barry C. Picker, CPA, PFS, CFP, is a shareholder in the Brooklyn, NY-based accounting and financial planning firm Picker & Auerbach, CPAs, P.C., and regularly consults with other professionals on a retirement planning issues. He is the author of Barry Picker’s Guide to Retirement Distribution Planning, is a member of the NYS Society of CPAs Estate Planning and Personal Financial Planning Committees, a former chairperson of the NYS Society of CPAs’ Employee Benefits Committee and a member of the Estate Planning Council of New York City.