The Internal Revenue Service (IRS) has issued a ruling that may help early retirees preserve the assets in their retirement accounts battered by the bear market. But not all early retirees may want to take advantage of the offer.

The ruling from the IRS allows taxpayers who have begun early withdrawals from one or more of their retirement accounts to switch, without penalty, the method they use to calculate their required withdrawals. The change in methods may slow the rapid depletion of accounts that have suffered steep losses in the current bear market.

Here’s how it works. Generally, taxpayers who begin tapping one or more of their employee retirement accounts and individual retirement accounts before age 59 1/2 must pay not only income tax on their withdrawals, but a ten-percent early withdrawal penalty. One way to avoid the penalty (but not the income tax) is to use what’s called a 72(t) strategy. This involves making a “series of substantially equal periodic payments” using one of three methods allowed by the IRS, and making these withdrawals for at least five years or until you turn 59 1/2, whichever is longer. For example, if you start at age 50, you must continue until age 59 1/2; if you start at age 56, you must continue until age 61. At that point, you can stop the withdrawals until you begin required lifetime minimum withdrawals after you turn age 70 1/2.

Two of the three calculation methods—amortization and annuitization—result in a fixed amount that must be taken out annually for the entire “periodic payment” period. The third option is a life expectancy method that is similar to the minimum required distribution method used in annually calculating withdrawals from your retirement accounts once you turn 70 1/2. The amount under this method changes each year depending on your remaining life expectancy and the changing balance in the account.

Until the recent IRS ruling, you had to stick with the method you chose until the required period was up. If you stopped or reduced payments, you paid a ten-percent penalty on the previous withdrawals, plus interest charges.

Of the three methods, the life expectancy method usually provides the smallest payouts. The two fixed methods typically produce higher payouts. When accounts were flush in the late 1990s, taxpayers making use of the 72(t) strategy often felt comfortable choosing one of the fixed methods because they wanted the higher payouts. The crunch arose when those high-flying accounts began tumbling badly. Retirees were still required to take out the high fixed payouts despite shrinking balances, and they suddenly were faced with the prospect of rapidly draining their accounts—perhaps to zero.

The IRS ruling allows taxpayers who chose one of the two higher-payout fixed methods to make a one-time switch, without penalty, to the life expectancy method. Under this method, they’ll never completely drain the account for as long as they live because it’s recalculated every year, allowing for smaller withdrawals. Furthermore, even single taxpayers can use the new joint life expectancy tables the IRS issued in 2001 for calculating withdrawals, and these new tables allow smaller payouts than the older tables.

Does it make sense to switch? That depends, of course, on your personal financial situation. Some taxpayers chose one of the fixed methods because they required larger payouts than they would have been able to take under the recalculation method. Despite the fact their retirement accounts may be significantly diminished, they may still need those larger payouts and can’t afford to switch to a method that would require smaller payouts. And remember, once you make the switch, you can’t change your mind later and switch back.

Also remember that you can stop withdrawals after five years or when you reach age 59 1/2, whichever is longer. If you’re close, wait until then and simply stop the withdrawals or take out only as much as you need until you have to begin taking minimum withdrawals after you reach 70 1/2.

Taxpayers thinking of using the 72(t) strategy because they are retiring before age 59 1/2 should carefully run their decision past a financial planner. There are techniques for making the best use of your retirement accounts, and you may find that there are better alternatives to using the 72(t) strategy.

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December 2002 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community.