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George Saenz, the Bankrate.com Tax Talk columnistAvoiding the early withdrawal penalty

Dear Tax Talk,
I am currently 35 years old and plan on retiring at the age of 47 or 48. With conservative estimates I should have about $1.5 million. The majority of the money will be in my employer's 401(k) and a Roth IRA. I expect to have about $60,000 in dividend income from stocks at retirement. My question is: If I retire at that age and only live off the dividends, will I be subject to the 10 percent early withdrawal penalty of retirement accounts?
-- Larry

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Dear Larry,
You can draw from your pension plans at any age without penalty, provided the withdrawals are made systematically. The systematic withdrawal is considered to be an annuity from your retirement accounts, and a properly structured annuity avoids the 10-percent penalty regardless of your age. You must use an IRS-approved distribution method, and you must take at least one distribution, annually, for this exception to apply. The required minimum distribution method, when used for this purpose, results in the exact amount required to be distributed, not the minimum amount.

There are two other IRS-approved distribution methods that you can use. They are generally referred to as the fixed amortization method and the fixed annuitization method. These two methods are more complex and generally require professional assistance. See Revenue Ruling 2002-62 in Internal Revenue Bulletin 2002-42 for more information on these two methods.

The payments under this exception must generally continue until at least five years after the date of the first payment, or until you reach age 59½, whichever is later. If a change from an approved distribution method is made before the end of the appropriate period, any payments you receive before you reach age 59½ will be subject to the 10 percent additional tax. For example, if you get bored with retirement and decided to go back to work after eight years (age 55 in your example), you must still continue your withdrawals until you reach age 59½.

Whether any of these amounts will get you the $60,000 depends on the balance in your accounts and not the income earned on the accounts. For example, at age 48 under the required monthly distribution method, your distribution would be 1/36 of your account balance. That's because at age 48 you have a life expectancy of 36 years. This translates into 2.77 percent of your account balance, so if your dividend yield is more than this you will not be getting the full amount of dividends your accounts earn.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy-- Posted: April 13, 2006
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