If you are no longer working for an employer, you have the option to roll over, or move, your 401(k) into another retirement planning vehicle. Some investors may choose to use an IRA, but others may opt to put a portion of the savings into a life insurance policy with cash value. You can do this before age 59 1/2 and avoid the additional 10 percent tax penalty by utilizing an exception to Rule 72(t) of the IRS tax code involving IRA funds.
Following Rule 72(t)
Under Rule 72(t) of the IRS code, you pay an additional 10 percent tax for any distributions from your retirement plan before age 59 1/2. This is over and above the ordinary income tax that applies to the withdrawal. Your employer contributed a portion of your paycheck and possibly matching funds into the 401(k). You incurred no taxes, and the funds grew tax-free while in the 401(k). At age 59 1/2, you can start withdrawing the money. However, you’ll have to pay ordinary income tax on the withdrawals, unless it’s a Roth 401(k).
Exceptions to the Rule
To avoid the additional 10 percent tax, you have to withdraw the funds in “substantially equal periodic payments.” To qualify for this exception, you must make these periodic payments over your life expectancy or the life expectancy of your designated beneficiary. The IRS allows three methods for calculating these payments that make use of a mortality table. Once you set these payments up, you cannot adjust them within five years of your initial payment except for a death or disability. If you do make changes, you’ll lose the exception and have to pay the 10 percent tax.
Because you can only use this exception with IRAs, you will need to roll over your 401(k) into an IRA, then take distributions from the IRA. To do this, simply request a direct rollover form from your 401(k) administrator and open an IRA with your broker or bank. If you do a direct rollover to an IRA, you will not incur any tax consequences.
Purchasing Life Insurance
Next, you should set up your permanent life insurance policy. You need to use a permanent policy, such as whole or variable life, because it has a cash value and offers you retirement planning options and tax benefits. After you apply for the policy, contact your brokerage or financial adviser to get the paperwork for withdrawing funds under the Rule 72(t) provisions. To figure out your periodic payments, it is a good idea to work with a financial or tax adviser who is experienced with calculating these types of payments. If you do this properly, the IRS taxes the payments as ordinary income, but will not assess the additional early distribution tax.