5 Steps To Retiring Rich (Step 5)
Dear Rich Lifer,
This is the fifth of five roadmaps on retirement accounts.
And, boy… I really did save the best for last.
In fact, I’m going to show you two powerful “hacks” that can:
— Get your money out of an IRA at any point… penalty free. Or…
— Leave it in as long as possible for future generations.
Let’s start with getting the money out.
As I’ve explained before, the IRS typically imposes a 10% penalty on people who take money out of 401(k) plans or IRAs before they turn 59 and a half years old.
Yes, there are some exceptions to this basic rule, including:
- Contributions made to a Roth IRA
- Some 401(k) hardship withdrawals
- 401(k) withdrawals that use the Rule of 55
- Up to $10,000 from an IRA used for the purchase of a home (if you haven’t owned one in the last two years)
- Certain IRA withdrawals used for qualified higher education expenses
But by and large, all you will hear is that there is no real way to universally avoid the 10% early withdrawal penalty.
Enter a method called “substantially equal periodic payments” (SEPP). It’s made possible by Section 72(t) of the Internal Revenue Code.
As the name suggests, this will NOT allow you to get all the money out at once.
But it will allow you to withdraw a predetermined amount every month over a certain period of time.
That period must be at least five years or until age 59 and a half, whichever comes later.
Here are two illustrations that show what I mean:
If I’m age 40 and I want to use SEPP, I will need to take the payments until I turn 59.5 years old. That’s roughly 20 years from now.
Meanwhile, if my cousin is 57 and he wants to use SEPP, he will need to take those payments until age 62 … which is past the normal 59 and a half cutoff.
If you go this route, you need to be committed. In fact, the IRS will actually assess penalties on all the money you’ve collected if you decide to abandon your SEPP prematurely.
You do have some flexibility in how you design the payments though. For details on the three methods and other ins and outs, see this document from the IRS.
Who might want to use SEPP?
Well, one great possibility would be a retiree using the payments to fund their life to a predetermined point in the future when another income will kick in. For example, using the SEPP as a bridge to a delayed Social Security benefit filing.
Someone in my age bracket might also consider a SEPP plan to pay their mortgage in the event of a job loss or some other major life event. They could even start contributing to their retirement plan again in the future, which would essentially wash out the overall financial impact.
Ok, that’s retirement hack #1 for today. Now, let’s cover #2.
On the other end of the spectrum, you can use a Roth IRA to pass along serious wealth to future generations.
Remember, Roth IRAs have no required minimum distributions… no future tax burden … and no age-related contribution restrictions.
That means you can keep all your money in there, and even keep funding the account, as long as you live.
What’s more, your heir will get a few choices on how to deal with the account.
Your spouse can roll the money into his or her own Roth IRA, which would allow them to continue avoiding required minimum distributions on the money.
Otherwise, the remaining choices (for a spouse or anyone else) are
- Withdraw the whole amount by December 31st of the fifth year after your death or …
- Starting taking minimum distributions based on the beneficiary’s own life expectancy. For spouses, the RMDs must begin either December 31st after the year of the account owner’s death or the year they would have turned 70 and a half, whichever is later. For everyone else, it’s just December 31st following the year of the account owner’s death.
Under either scenario, the proceeds should be tax-free (with the possible exception of estate taxes). But option B. is the really powerful choice here.
Why? Because the combination of the RMDs and the tax protection should allow the account to stretch out over a very long time … especially if you designate a very young beneficiary.
Here’s an example …
Say you leave your $100,000 Roth IRA to a granddaughter who is 15 at the time of your death.
If they decide to take required minimum distributions, the IRS will use its actuarial tables from publication 590 to figure out how long the granddaughter will live. In this case, it’s 67.9 years.
That number becomes the divisor for the entire account value, and it drops by 1 in every subsequent year.
So since your granddaughter has to take her first distribution by the end of the year following your death, her first distribution is $1,494.77 ($100,000 divided by 66.9).
And by the way, your beneficiary gets to name their own beneficiary who will be able to take advantage of all the same distribution rules.Just think about an account that is invested in stocks with steadily rising dividend payments, which are also largely being reinvested.
It’s possible to see that portfolio kicking off tax-free distributions for a very long time, maybe even multiple generations!
Now, yes, there are two caveats here:
First, you need to know that your heirs are responsible enough to see the plan through.
And second, you need lawmakers to keep their promise regarding tax protections on Roth IRAs.
Still, it’s a pretty interesting path to consider.
If you’re interested, you can even consider converting any assets you currently have in a traditional IRA over to a Roth account.
You will owe taxes on the amount you convert, and could even get bumped into a higher bracket or affect your tax picture in other ways.
At the same time, there are no longer any income restrictions on doing these conversions.
Plus, if you are already close to the point of RMDs, even the tax implications might not be as big of a deal. Just remember that unless you’re 59 and a half or older, the tax bill will have to be paid with outside money or else you’ll face a 10% penalty on the Roth amount you use.
To a richer life,
Editor, The Rich Life Roadmap