How to tap retirement assets early with a minimal tax bite

Penalties can take more than 10% from a payout. There are several ways to get at least part of your retirement money out without penalties, but professional help may be warranted to avoid missteps.

Unemployed and strapped for cash?

Your retirement plan may look tempting as a source of new money, especially when you're out of work. But taking money out of a retirement plan subjects you to enormous tax penalties that can cut your savings in half, so most advisors say it makes sense only as a last resort.

But if you must, the key is to tap retirement money carefully to reduce the tax hit.

"There's an overriding misconception that there's an exception to the tax penalties for financial or economic hardship," said Ed Slott, a New York accountant who is an expert on retirement plan rules and pens a monthly newsletter called Ed Slott's IRA Advisor. "There is no exception. You can't take money out of a retirement plan penalty-free just because you lost your job."

That said, there are ways to avoid tax penalties. And avoiding penalties is important because they zap more than 10% of your savings. Withdraw $10,000, and $1,000 in penalties are due to Uncle Sam.

Many state tax authorities impose additional levies. California, for example, will eat up a further 2.5% of the withdrawn amount. So that $10,000 gets whittled down to $8,750 -- and that's before you pay regular income taxes to both the state and federal governments, which are always required on retirement withdrawals.

There are several ways to get at least a portion of your retirement money out without paying penalties. But there's just one method that works for all types of retirement plans -- the "substantially equal periodic payments" or "the 72(t)" method of retirement withdrawals. (Section 72[t] of the tax code spells out the rules for penalty-free early retirement plan distributions. Accountants, being clever wordsmiths, thus call these penalty-free early withdrawals "72[t] distributions." To be fair, there's no snappy way to say it.)

How does it work? In a nutshell, you spread out your retirement payments over your remaining life span, taking "substantially equal" annual payments for the rest of your life.

You can actually stop taking payments -- or boost your payments -- after age 59 1/2 . But any amount you take out before you hit that magic age must be based on the formula and cannot change from year to year.

The catch? There are three.

First, it's complicated to figure out how much to take because there are three ways to calculate the right amount and the more complex of these often provides the most generous annual payments.

Even the IRS' Publication 590, which attempts to explain how to do these withdrawals correctly, says that two of the calculations shouldn't be attempted without professional help.

Second, if you're relatively young, none of the methods is going to net you anything near a living income.

A 40-year-old with $100,000 in retirement savings, for example, could withdraw a maximum of $4,468 a year, or about $372 a month, Slott calculates. A 50-year-old would be able to take out $5,025 a year, or about $419 a month.

There are some calculators on the Web that can help you estimate the amount you could receive based on your age and assets, including a nice one at www.dinkytown.net/java /Retire72T.html, but before you play with real money, hire a professional to confirm the numbers.

Finally, you've got to keep taking these "substantially equal" payments until you are 59 1/2 . If you fail to take a distribution before that age -- or change the amount you take in any way -- you get slammed with penalties.

And the penalties are steep, Slott said. The IRS will go back to the date of the first distribution and retroactively impose early-withdrawal penalties and interest on every dollar withdrawn, even if you've been taking the withdrawals without a hitch for 20 years.

"One misstep and you're in a big hole," he said.

"The younger you are when you start taking distributions, the more likely you are to make a mistake."

What are the other options? That depends on the type of retirement plan you hold.

If you've got a workplace retirement plan, such as a 401(k) or a 403(b), and you're over the age of 55 when you separate from employment, you can start taking retirement distributions right away. If you choose this option, you'll pay income taxes on the distributions, but no penalties.

The catch: If you separate from employment before age 55, this exception does not apply to you. You can't, for instance, leave your job at age 53, leave the money alone for two years and hope to start taking penalty-free withdrawals at age 55.

So what do you do if you're younger? Slott suggests you roll your 401(k) into an IRA, which allows more penalty-free withdrawal options.

IRA assets can be withdrawn without penalty for three reasons: to pay college tuition, to handle a permanent disability and to pay medical insurance premiums if you are unemployed.

Beware the disability exception, though. Slott said that the tax code's definition of disability is stricter than those that will qualify you for disability insurance payments. If you ever work again, the IRS will say that earlier disability-exception distributions were improper and are subject to penalties.

Of course, withdrawing only enough to pay tuition or insurance premiums isn't going to be sufficient to handle all of your expenses. But it can at least get a portion of your savings out of retirement plans penalty-free.

Any additional money should be taken out solely as needed, Slott said. The less you withdraw, the less significant the tax hit and the easier it will be to restore your savings when these tough times pass and you go back to work again.

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