It's another cold gray day with the usual frustrations and vexations of practicing law. But, once again, the market is up. Across the State, forty and fifty something lawyers consider the ever increasing sums in their qualified retirement plans ("Plans") and individual retirement accounts ("IRAs") and contemplate early retirement.
You may be wondering whether distributions from the Plan maintained by your employer or the IRA into which you rolled distributions from other Plans are your ticket out of here. The good news is tax law permits practically any distribution a reasonable person could wish. The bad news is that limitations on annual contributions and restrictions on investments imposed by the Employee Retirement Income Security Act of 1974 ("ERISA") usually prevent employees from accumulating enough money to retire young. Some folks make enough money outside Plans to permit them to retire. They should finance the early years of their retirement with those outside funds, letting the funds inside their Plans continue to earn tax-deferred income.
Thus, few need to think about early distributions. Still, people wonder. This article tries to answer a few of their questions.
The 10% Penalty Tax
First ask, 'does my Plan permit early retirement?' This can only be answered by reading the terms of the Plan, but most lawyers assume that if their Plan doesn't permit early retirement, amendments will do the trick. The big concern is usually the 10% tax on early distributions imposed by Section 72(t). The tax does not apply to distributions made by reason of death or disability or in years after the recipient attains age 59 and one/half. We are concerned here with able-bodied folks of a lesser age.
If you are over 55 and separate from service (i.e. retire) there is no penalty tax on distributions. However if there is a large distribution it almost always turns out to be better planning to roll most or all of it into an IRA to avoid unnecessarily accelerating the regular income tax.
Generally the way to avoid the penalty tax is to take "substantially equal payments" over your life or the joint lives of you and your spouse. No penalty is imposed as long as the distribution formula is not modified before the later of the fifth year after commencement of distributions or the year in which you attain 59 and one-half. After the expiration of this period, you are free to withdraw as much or as little as you choose until you reach 70 and one-half, when the minimum distribution rules begin. However, if there is a modification before the permitted time, all amounts ever distributed up through the date of modification, plus interest, become subject to the tax.
Substantially Equal Payments
The Internal Revenue Service (the "Service") provides three ways to calculate the amount of the payment. The first uses the method from the minimum distribution rules. First determine the age of yourself and your spouse. Then find an "expected return multiple" (roughly, but not exactly, life expectancy ) from tables. The multiple will be larger for a joint life than a single one. The first year's distribution will be the reciprocal of the multiple times what is then in the account. For example at age 50 the multiple is 33.1 so 3.1% of the balance would be distributed. If a joint life is used and both are 50, the multiple is 39.2 and 2.6% would be distributed. You must make an irrevocable choice at the outset. You may decrease the multiple by one each year (giving an annuity over a life expectancy determined as of the date of commencement). Alternately you may use the appropriate multiple from the table for subsequent years (32.2 at age 51 rather than 33.1 - 1 = 32.1)based on then attained ages (giving an annuity based on your actual life or lives). In either case the reciprocal of the multiple is applied to the then current balance in the Plan or IRA from year to year. The reciprocal increases with time and since distributions are small, the balance in the fund is likely to increase, so that the amount distributed increases with time.
This method usually permits an initial distribution for a married person of less than 3%. Theoretically this is desirable. We want just enough from the IRA to meet our needs, leaving the rest to grow on a tax deferred basis. However most attorneys want more. This leads us to methods two and three.
The second alternative involves selecting a life expectancy, for either you or you and your spouse and using a reasonable interest rate to compute a fixed payment over that expectancy, similar to computing a level payment on a mortgage. The life expectancy is based on the multiples discussed above. If the interest rate is 8% and the period at age 50 is 33.1 years the payment is 8.69% of the initial balance and does not change from year to year.
The third method is to compute the payment using an annuity table and a reasonable rate of interest. Using the UP 1984 Mortality Table , and 8% interest rate, the initial distribution at age 50 would be about 9%.
Reasonable Interest
As of January 2000 the Federal long-term interest rate, computed on an annual basis was 6.45%. The long-term rate applies to obligations with maturity longer than nine years. Given a life expectancy of more than 30 years at age 50, it seems reasonable to suppose that the long term rather than the short-term or mid-term rate is the appropriate benchmark. For certain valuation purposes, the Code uses 120% of the federal mid-term rate , which in January 2000 was 7.47%. The federal rate, however, represents a risk free rate. By diversifying investments, as in a mutual fund, a higher rate could be obtained with an acceptably low risk. 8% seems defensible and, in view of the absence of reported litigation in this area, a 9% rate, though aggressive, would probably not be challenged. Using method 3, this permits a distribution of 10% of the original balance each year.
Why Not More?
Clever lawyers reading this piece have doubtless thought of irrefutable arguments for yet higher distributions. The trouble is that when one looks at actual investment performance, one finds that once distributions exceed 4 or 5% there is a distressing tendency to run out of money before death, often much before death . Suppose we start at age 50 with a million dollars and take out, at the beginning of the year, $100,000, but the market declines twenty-five percent. The balance is $675,000. The second year we take out another $100,000, leaving $575,000. The market increases 12% so our balance goes to $644,000. After taking out $100,000 at the beginning of year 3 the balance is $544,400. Another 12% increase and $100,000 payment leaves $610,000 after the year 4 distribution. Suppose the market continues to increase 12% every year. After a dozen years the account will be gone even though in 11 out of 12 years the earnings were 12%. The participant gets to go back to work at age 63, having not practiced in a dozen years.
Most people, on reflection, will choose distributions between 4 and 6% of their balances. Those with confidence in their investment abilities might go to 8%. They will recognize that after five years and reaching age 59 and one-half they can increase their expenditures if the funds are there.
Four to six percent of the retirement plan balance of a fifty something year old doesn't pay too much college tuition or go too far toward maintaining the life style to which you may have grown accustomed. Most of us need to continue paying bar dues and keeping up with CLE.
