The Penalty-Free Way to Withdraw Retirement Money Early

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It's widely know that for most retirement plans, including an IRA and 401K, there is a cost to withdrawing money before you reach 59-½ years of age. Take money out of a traditional IRA or 401K early and you're stuck paying taxes plus a 10% early withdrawal fee. If you withdraw money from a Roth IRA early, you'll have to pay tax on any withdrawn gains.

There are some ways to avoid this penalty, including one mechanism that may be unknown to many investors.

It's called a SEPP (stands for Substantially Equal Periodic Payment), and it may help some investors access their money early without a cost. The basic idea behind a SEPP is that you can receive regular payments (usually annually) from your retirement account, as long as they are a consistent amount and you do so for a certain length of time.

Here are some key things you need to know.

1. You Must Take Withdrawals for at Least Five Years

Once you begin a SEPP program, you are required to make regular withdrawals for five years or until you are 59-1/2, whichever comes last (with some exceptions for disability or market decline). So for example, a person who is 56 must make withdrawals until they are 61. A person who is 45 must continue to make withdrawals for the next 14-1/2 years. Thus, it's generally not a good idea to embark on a SEPP program if you are young. If you stop the program before the required time is up, you must pay the IRS all of the waived penalties, plus interest.

2. Calculating Your Payments Is, Well, Complicated

Okay, so you're required to make regular withdrawals of the same amount of money. But how much should you be withdrawing? There are three main methods of determining this.

The Required Minimum Distribution Method

In simple terms, divide your total account balance by your life expectancy. (The IRS has a table to help you determine this.) Under this method, the amount you withdraw must be recalculated each year and could change.

The Fixed Amortization Method

Under this system, payments are based on the life expectancy of the account holder and a chosen interest rate.

The Annuity Method

To determine payments under this system, divide your account balance by an annuity factor that is based on your age.

Generally speaking, the Required Minimum Distribution method is the most straightforward and will result in the smallest payments. This makes it a better choice for investors who do not want to deplete their accounts as quickly. However, payments must be recalculated each year, whereas the other two options only require calculations to be made once.

3. It's Not a Good Idea for an Emergency

There may be times when you are tempted to withdraw from your retirement account to take care of a financial emergency. But a SEPP isn't designed to help you with that. The five-year requirement makes it impossible to make a single withdrawal or even a small series of withdrawals. If you have a one-time emergency, you're better off find other methods to get cash quickly.

4. It Won't Always Work for a 401K

If you're considering using a SEPP to withdraw money from a 401K plan, the IRS requires you to first separate from the employer that maintains the plan. So once again, this is not a decision to make lightly. That said, 401K plans from previous employers are acceptable, as are any rollover IRAs you created from past plans.

5. It Is Not Easily Adjustable

Once you sign up for a SEPP program, there's no way to cancel it before the required time. If you find that your payments are too much, you can change your calculation method to the Required Minimum Distribution method. But this change is only allowed once.

6. You Must Stop Contributing

Once you decide to use a SEPP program, you can't adjust the balance of the retirement account. That means no more adding money to the account and no separate withdrawals. Any change to the account balance could lead to the SEPP being disqualified, in which case you're on the hook for all of the penalties and taxes, plus interest.

7. Withdrawing Money Early Means You Will Have Less Later

It's important to remember that a retirement account is called a retirement account for a reason. Your goal should be to ensure that money in the account lasts for the entire time after you are done working. That could mean decades. So if you are withdrawing money early, understand that you are reducing the amount that will be available to you later in life.

8. You Probably Need Professional Help

A SEPP is not an easy thing to understand or set up yourself. A tax and investment adviser will help you understand if a program is right for your particular situation, and walk you through the steps to determine the proper payments.