Top 15 Things TO DO When Planning Early Distributions

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In this article I want to share a list of steps you can use for planning early distributions from your retirement accounts. Each step will be the subject of its own article shortly. The SEPP (Substantially Equal Periodic Payments) exception of the IRC Section 72t is the most commonly discussed, so the article has a bent towards that subject. However, this article can also be applied to other exceptions (Medical, Disability, College, etc.).  

Disclaimer: While I’ve successfully financed my early retirement with my 72t SEPP plan, I am not an accountant, a financial advisor, or the IRS and as such the steps below are not intended to be a complete reference. My process may be inaccurate, I may have misunderstood the law, or I may have missed a step. Please use this as a guide to understand the major steps, but please do not implement your plan until getting an OK from a professional.

  1. Gain a thorough understanding of your spending and other income sources. Track spending for several months to two years (recommended) to get a reliable estimate. It’s best to estimate your spending and income throughout the time you will be taking your early distributions, and plan conservatively so you don’t underestimate expenses or overestimate income.
  2. Calculate how much you need to withdraw from your retirement accounts. The amount you decide upon generally cannot be changed (there are a few exceptions) after you start. Consider the taxes that will need to be deducted and when to deduct/pay them (monthly, quarterly, annually).
  3. Select the retirement account(s) you plan to withdraw from. Retirement accounts are owned by an individual and must remain so according to federal laws, so you cannot physically combine them (yours and your spouse’s, for example) when drafting your 72t plan.
  4. Understand the applicable federal rate rule and how it applies to calculating withdraw rates. There is a very small range of interest rates you can use to calculate your annual distribution amount, and the date you start taking distributions is an important factor in deciding the rate. *Note: some SEPP calculators allow you to enter any “reasonable” interest rate – don’t. Find the current applicable federal rate (probably in the 3% range) and use that instead.
  5. Confirm with your brokerage firm that it will allow early distributions. Move your money using a trustee-to-trustee transfer if your brokerage does not allow early distributions. Understand all rules and regulations of the brokerage firm with respect to the early distribution process. Understand how the firm will or will not help you with the process. Some brokerages will not provide any help other than answering basic questions, will not corroborate that you are entitled to the 10% penalty exception, and will not allow for automated withdraws before age 59 ½. Does your brokerage charge any fees for taking early withdraws?
  6. Pick a start date. The start date of your SEPP is important for a few reasons. It will help you calculate the starting balance, determine the applicable federal rate, and calculate the end date of the plan. Consider the range of applicable federal rates (AFRs) you can choose from and select the one that is best for your plan. You can choose from the current month’s AFR or the prior 2 months’ AFRs.
  7. Calculate your end date (first modification date). Your end date is the maximum of 5 years or age 59 ½, whichever comes last. So, if you start when you are 40, you need to continue taking distributions until you are 59 ½ (19+ years). If you start when you are 55, you need to take distributions until you are 60 (5 years). The end date is also called the first modification date because in either case you have passed your 59 ½ birthday and can withdraw as much or as little from your retirement accounts as you want.
  8. Calculate your starting balance. The starting balance can be the balance in your chosen retirement accounts on the start date, or it can be calculated using any “reasonable” method and timeframe (such as end of year the prior year).
  9. Decide on tax withholding. Brokerages are required to withhold 20% from 401k plan distributions, but generally you can choose the tax withholding on distributions from IRAs. Your brokerage will probably suggest 10%, but you can override that and select a different amount if you want. You can choose to withhold your effective tax rate (your accountant should be able to tell you your effective tax rate), or zero. If you choose zero you may want to consider paying quarterly taxes to the IRS so 1) your tax bill isn’t huge in April and 2) you need to pay penalties in April because you didn’t pay enough in taxes throughout the year.
  10. Decide on a life expectancy table, annual recalculations, and first year distribution amount. The single life expectancy table will likely net you the largest withdraw amount. Annual recalculations are allowed by the section 72t rules, but more calculations leaves more room for error. The first year is unique in that you can choose to take the entire distribution amount or a pro-rated amount, depending on when you start your plan. For example, if you start on March 31, you can take 100% of your annual distribution, or 75%, whichever works best for you.
  11. Decide on a withdraw frequency (bi-weekly, monthly, quarterly, annually, ad hoc). You can choose to take your withdraws on any frequency that makes sense in your situation. Bi-weekly payments will most closely resemble a paycheck but check with your brokerage to make sure there are no transaction fees before deciding on this route. Also, if your brokerage does not allow for automatic payments, you will have to remember to take your bi-weekly withdraws. Any frequency is allowed, including ad hoc withdraws. The only requirement is that, by December 31, all distributions must have successfully been withdrawn from the account for the year.
  12. Develop a written plan. Document your plan with as many details as possible, including all of the information and selections from the steps above. Print the plan, date it, and keep it in a safe place. The IRS will likely want to see this plan if you’re ever audited. Coming soon: SEPP Initiation Worksheet.
  13. Confirm your plan with an educated accountant before you begin taking distributions. While section 72t has been on the books at the IRC since <date>, early distributions have been rare in the past. Be aware that not all accountants are intimately aware of the IRC section 72t. Considering the costly consequences of a poorly planned 72t distribution, it is in your best interest, and it is your responsibility, to seek advice from an accountant who is knowledgeable about 72t (and check with your financial advisor, too).
  14. Keep track of withdraws. After starting your distributions, carefully track each withdraw, with the date and the pre-tax amount withdrawn. DO NOT go over the annual distribution amount.
  15. Check in with your accountant early in the 4th quarter – before your last withdraw for the year. Print a distribution report from your brokerage and verify it against your records. Make sure you and your accountant agree on the amount of the final planned withdraw. Take the distribution by December 15 in case you or your brokerage make a mistake you can true up in plenty of time to make adjustments before December 31. Don’t expect in-flight withdraws that settle in January to be ok with the IRS. If there is a discrepancy, fix it before the end of the year. Check the 1099 you receive in January with your records to ensure accuracy.

Do you have anything to add to the Top 15? Please share in the comments below.

Posted in Distribution Plan.

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