Normally if you take money out of an IRA, 401(k), or other tax-qualified retirement account before you reach the age of 59 ½ you would be subject to a 10% federal income tax penalty on the distribution. But as noted by the IRS, there are several exceptions to this penalty.
One exception is if you receive a distribution from a retirement plan such as a 401k after you leave a job and you are at least 55 years old. You also qualify for an exception if you are disabled or you take the distribution in order to cover medical expenses, subject to certain requirements. Qualified first-time homebuyers can qualify for an exception for withdrawals of up to $10,000 from an IRA. The IRS provides a chart showing all the exceptions to the 10% penalty on early withdrawals from 401(k) plans, IRAs, and other types of retirement plans.
Another way to avoid the 10% penalty is to take “substantially equal periodic payments” according to Section 72(t) of the IRS Code. This exception would not help you if you don’t qualify for any of the exceptions and you need to take a withdrawal in a lump sum. But if you can plan your finances and withdraw from your retirement account in regular installments, this exception can allow you to avoid the 10% penalty. You would still have to pay income tax at your normal rate on the taxable portion of the distributions.
In order for the exception from the 10% additional tax to apply, you must receive the substantially equal periodic payments for at least 5 years or until you reach age 59 ½, if later. According to the IRS, if you do not follow the plan or you subsequently modify the payment amounts, the 10% additional tax applies retroactively to the entire period you were receiving the payments.
IRS Revenue Ruling 2002-62 provides guidance on how the payments can be determined. There are three methods you can use: the required minimum distribution method, the amortization method, and the annuitization method.
Under the required minimum distribution method, you would take the balance in the retirement account and divide it by the life expectancy. Under this method the annual payment is recalculated each year.
Under the amortization method, the balance in the account is divided by a specified number of years according to life expectancy and multiplied by an interest rate that is not more than 120% of the federal mid-term rate. Under this method the annual payment stays the same in future years.
The annuitization method uses the account balance, an annuity factor based on a mortality table, and an interest rate. The annual payment in future years also remains the same under this method.
You could use a calculator such as the one provided by Bankrate to calculate your maximum distribution according to the 72(t) exception and the effect the distributions would have on your retirement account balance.
72(t) distributions: Impact on retirement fund balances, Bankrate
Exception to 10% Additional Tax, IRS
Retirement Plans FAQs regarding Substantially Equal Periodic Payments, IRS
Retirement Topics – Tax on Early Distributions, IRS
Revenue Ruling 2002-62, Internal Revenue Bulletin No. 2002-42