Retiring early on a 401(k)/IRA without penalty
By Laura Bruce • Bankrate.com

One of the best ways to have enough money for retirement is to contribute to your IRA or 401(k) and leave it alone -- let the money grow. Take advantage of company matching dollars and deferred taxes and, ideally, if you started the plan early enough you won't have to find a part-time job asking, "Paper or plastic?" when you're 70.

But if you want to retire early -- or if you're seriously strapped for cash and need to tap your retirement money -- there's a way to do it without triggering a penalty.

For the most part, if you take money out of an IRA, 401(k) or pension plan before age 59 1/2, you have to pay a 10 percent penalty on top of ordinary income taxes.

Avoiding the penalty
The exception is if you take the money out in "substantially equal payments" during your life expectancy. Internal Revenue Service rules require that you take at least one payment annually for the exception to apply. Actuarial tables are used to determine life expectancy and, in essence, you're turning your retirement plan into an annuity, also called an "annuity distribution," or for the truly bureaucratic, "annuitizing an IRA."

Certified public accountant Darryl Hinkle of Hinkle and Richter in Pompano Beach, Fla., says he's seen very few people take advantage of this -- and for good reason.

"Say a 35-year-old guy has $100,000 in an IRA. He decides to take the money out. He'd have to take it out over 40 years -- so, he'd take $2,500 a year. This limits the ability for that money to grow. You have to swallow hard when you go into one of these things."

Furthermore, if our 35-year-old guy decided a couple of years later that he didn't need the $2,500 and wanted to reduce his payments to $2,000, the IRS would slap him with the 10-percent penalty. The rules say you can't change the payment plan for five years or until you reach age 59 1/2, whichever is greater.

Marriage makes a difference
Of course, there's an exception to that rule, too. If a husband and wife take the payments out together and one spouse dies before age 59 1/2 or before they've had the account open for five years, the surviving spouse can adjust the payments based on his or her own life expectancy without penalty.

Hinkle says there are circumstances where it might make sense to take such an annuity distribution on a retirement plan.

"If someone's in their 50s and lost their job, he might say, 'I've got a half-million dollars here and I need to tap into it. What the heck, I'll start now.' That's more conceivable."

The annuity distribution can be set up as a one-life annuity or a two-life annuity for married couples. If it's a one-life and the person is 55 years old, according to the actuarial table that person will live an additional 28.6 years. If it's a two-life, based on the life expectancy of both spouses, the table says both will have died within 34.4 years. So if you have a $500,000 IRA and you opt for the single-life table you divide $500,000 by 28.6 for an annual payment of $17,482.52. Using the two-life annuity, you divide $500,000 by 34.4 for an annual payment of $14,534.88.

Be aware there are plenty of other situations where you can withdraw money from a 401(k) or IRA before age 59 1/2 without penalty. They include disability, buying a home for the first time and paying medical expenses that are more than 7.5 percent of your adjusted gross income. If you're interested in tapping your retirement fund early, check with the IRS or your accountant to see if your situation qualifies you to do so without penalty.

-- Updated: May 4, 2001