Dual income families and lucrative 401(k) plans have become regular socio-economic trends that have made many people think about opting for early retirement. If you choose to retire early and change your 401(k) plan into an IRA, how do you go about preparing a withdrawal plan?
It depends on the nature of IRA you have. There are different rules for Roth IRAs. Moreover it depends on if you are planning to retire before or after age 59 1/2. Here we are going to think 59 ½ as the retirement age.
Which Income is Taxed?
The first problem is to understand the rules that define what are regarded as taxable income. For traditional IRAs, the entire income is taxable. But if you make non-deductible contributions to a traditional IRA, SEP or SIMPLE IRA, distributions are pro rata. All deductible contributions and earnings are taxable. The non-deductible contributions are tax-free, simply because you have already paid tax on them.
Distributions from Roth IRAs are first treated as though coming from your contributions initially and from earnings later. Moreover, Roth IRAs are governed by a “qualified distribution” rule. The first condition is that you should hold your Roth for 5 years. This time starts from the moment you make your first Roth contribution. If you have completed this 5 year rule, are below 59 ½ years, and disabled, you can withdraw contributions and earnings totally tax-free.
The 10% Early Distribution Penalty Tax
Withdrawals from IRAs which can be included in income and opted for before 59 ½ years attract a 10% early distribution penalty tax, unless there is an exclusion clause. According to the above discussions, the contributions to Roth IRAs cannot be considered as income when withdrawn.
These are the exceptions:
Death. It is not a great method to begin your early retirement, but is an exception.
Disability.
Withdrawals constituting “substantially equal periodic payments” (SEPPs). This approach is one of the most feasible solutions to early retirement.
Medical care, subject to rules on the deductibility of these items that is presently applicable to those medical expenses exceeding 7.5% of your adjusted gross income.
Health insurance premiums for the unemployed.
Payments made towards qualified higher education expenses, not only for yourself but also for others in the family.
First time homebuyers up to $10,000. This is applicable not only to yourself but also others related to you.
Kept as a reservist while on active duty. This latest exception was first introduced in the Pension Protection Act of 2006. The exception period is between 9/11/01 and 2008.
This information should help you plan your early retirement