Retiring early and tapping your IRA before you're 59 1/2

If you're a military member considering retiring completely after 20+ years of service, you are certainly concerned about how you can access savings in IRAs and perhaps in your TSP if you're putting money away in these accounts. You know that these accounts generally cannot be accessed before you're 59 1/2 without suffering a 10% penalty.

There is another option, however. Using section 72(t) of the tax code you can, in fact, take annual payments out of these accounts. The discussion below is from the IRS web page.

How are annual, substantially equal periodic payments determined for purposes of the required minimum distribution method, the fixed amortization method and the fixed annuity method?

An example of the required distribution method, an example of the fixed amortization method and an example of the fixed annuity method using the methodologies described in Rev. Rul. 2002-62 are set forth.

Facts:

Mr. B is the owner of an IRA from which he would like to start taking distributions beginning in 2003. Mr. B will celebrate his 50th birthday in January 2003. Mr. B would like to avoid the additional 10% tax imposed on early distributions under section 72(t)(1) by taking advantage of the exception in section 72(t)(2)(A)(iv) for distributions in the form of substantially equal periodic payments.

Assumptions:

the account balance of Mr. B's IRA is $400,000 as of December 31, 2002, and this is the account balance (and, when applicable, the date as of which the account balance is determined) used to calculate distributions.

120% of the federal mid-term rate for the appropriate month is assumed to be 4.5% and, when applicable, this is the interest rate that will be used for calculations.

distributions will be over Mr. B's life only and, where applicable, single life expectancy will be used for calculations.

1. Required minimum distribution method

For 2003, the annual distribution amount ($11,695.91) is calculated by dividing the December 31, 2002, account balance ($400,000) by the single life expectancy (34.2) obtained from Q&A-1 of § 1.401(a)(9)-9 of the Income Tax Regulations when an age of 50 is used.

$400,000/34.2 = $11,695.91

For subsequent years, the annual distribution amount will be calculated by dividing the account balance as of December 31 of the prior year by the single life expectancy obtained from the same single life expectancy table using the age attained in the year for which distributions are calculated. For example, if Mr. B's IRA account balance, after the 2003 distribution has been paid, is $408,304 on December 31, 2003, the annual distribution amount for 2004 ($12,261.38) is calculated by dividing the December 31, 2003 account balance ($408,304) by the single life expectancy (33.3) obtained from Q&A-1 of § 1.401(a)(9)-9 of the Income Tax Regulations when an age of 51 is used.

$408,304/33.3 = $12,261.38

2. Fixed amortization method

For 2003, the annual distribution amount will be calculated by amortizing the account balance ($400,000) over a number of years equal to Mr. B's single life expectancy (34.2) (obtained from Q&A-1 of § 1.401(a)(9)-9 of the Income Tax Regulations when an age of 50 is used), at a rate of interest equal to 4.5%. If an end-of-year payment is calculated, then the annual distribution amount in 2003 is $23,134.27. Once an annual distribution amount is calculated under this fixed method, the same amount will be distributed under this method in subsequent years.

3. Fixed annuitization method

Under this method the annual distribution amount for 2003 is equal to the account balance ($400,000) divided by the cost of an annuity factor that would provide one dollar per year over Mr. B's life, beginning at age 50 (i.e., the actuarial present value of an annuity of one dollar a year payable for the life of a 50 year old). The age 50 annuity factor (17.462) is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and an interest rate of 4.5%. Such calculations would normally be made by an actuary.

The annual distribution amount is calculated as

$400,000/17.462 = $22,906.88

Once an annual distribution amount is calculated under this fixed method, the same amount will be distributed under this method in subsequent years.

Using these techniques, the IRS basically allows you to create your own lifetime annuity with your IRA funds. Just remember that you'll need to structure your account to accommodate these distributions. I recommend you take a look at Ray Lucia's "Buckets of Money" strategy to ensure that you have sufficient liquid assets in order to prevent you from having to liquidate long term investments during market downturns to allow the distribution.

Another look at Tax Friendly Retirement States

Several postings ago I detailed states that were favorable for retirement based on taxes. An important thing to remember is that just because a state does not have an income tax that doesn't necessarily mean that the overall taxes in that state are lower. When you factor in property, sales, and inheritance taxes, the income tax states actually look more competitive.

According to Kiplinger's 2008 "Retirement Planning" magazine, 9 states* have no income taxes:

1. Alaska
2. Florida
3. Nevada
4. South Dakota
5. Texas
6. Washington
7. Wyoming

* New Hampshire and Tennessee tax only interest and dividends.

Five states have no sales tax:

1. Arkansas
2. Delaware
3. Montana
4. New Hampshire
5. Oregon

Eight states collect inheritance tax:

1. Indiana
2. Iowa
3. Kentucky
4. Maryland
5. Nebraska
6. New Jersey
7. Pennsylvania
8. Tennessee

When MSN Money examined a hypothetical case of a retired married couple living on an income of $60,000. When calculating their expected taxes that include all factors, the top six states for retirees were:

1. Delaware
2. Alaska
3. Kentucky
4. South Carolina
5. New York
6. Michigan

The highest state tax bill was in Pennsylvania, which due to an excessively large property bill, led all others, and that's before collecting their inheritance tax when you pass on.

While taxes alone shouldn't determine your retirement location, it's helpful to compare options if you're not determined to live in one state or another. Also, more than 20 states had a total tax obligation of less than 5% of the hypothetical retirement couples income. Given the services that an American receives for their taxes, I'd say it's still a very fair deal.

Homeowners' Assistance Program benefits are not taxable

Here are the words from the HAP webpage:

"Tax Liability of Expanded HAP Benefits
• President Obama signed HR 3548, Unemployment Compensation Extension Act of 2009, into law and thereby exempted Expanded HAP benefit payments from taxation. Read More…
• Applicants who received benefits and had taxes withheld, may apply for refunds from the Internal Revenue Service when they submit their tax returns."

Great news for everyone hoping to sell their homes and restart at their next duty or retirement location.

Putting your 3.4% to work

You know that your military paychecks are going up 3.4% beginning in January. Now's a great time to add that to your TSP withholding if you're not already maxed out. Because the increase comes out pre-tax, you'll still see an increase in your January paycheck. Here's how you do it.

1. Log into myPay. (Note: DFAS is updating all the account names to remove the Social Security numbers right now. You'll have to create a log-in name and new password. A minor pain, but for a good cause.)
2. "Agree" to the terms. There's a dialog box at the bottom of the first screen after you log in.
3. Select "TSP" from the options below "Taxes"
4. Under "Basic Pay" add 3.4% to your current contribution. (The maximum contribution for you is $16,500 in 2010.) Then select "Save".

You'll find a link in a previous blog to the percentage of your monthly check you need to save to max out your TSP.

Also, remember that you can also contribute $5,000 (or $10,000 if you're married) to a ROTH individual retirement account. You'll need to save $416.67/mo ($833.34/mo for a couple) in addition to your TSP withholding to max out your contributions.

Details on our Post 9/11 GI Bill Payment

My earlier post on our Post 9/11 GI Bill benefit tranfer payment was a bit brief given the workup since April 30th, so I thought I'd spend a few moments outlining what we actually received.

Our VA award letter was dated Nov 18, a full 6 1/2 months after I submitted my application for benefits.

Tuition and Fees:

• The school submitted information to the VA that verified that my son enrolled in the university from Aug 20 through Dec 20, with a full-time course load and total tuition of $14,778.50 and fees of $1,430.25.
• "The in-state maximum fees per term for your state (CA) is $287.00. Since we are entitled to receive 100% of the amounts payable under the program, you may be paid up to $2,165.25 for fees each term or 100% of the actual fees charged, whichever is less. Your school certified that you were charged $1,430.25 for 15 credit hours.
• "We issued a tuition and fees payment to your school on your behalf in the amount of $5,735.25."

Monthly Housing Allowance:

• "The monthly housing allowance payable under the Post-9/11 GI Bill for your school's zip code is $1,930 (Berkeley, CA). Since you are eligible at the 100% rate, you will receive $1,930 a month for each full month of training during the certified enrollment payment."

Books and Supplies Stipend:

• "The maximum amount payable for books and supplies is $1,000 each year. Since you are entitlesd to receive 100% of the amount payable under the Post-9/11 GI Bill, you may be paid up to $1,000 each year for books and supplies. VA pays a portion of the books and supplies stipend for each credit hour pursued during the year up to 24 credit hours. Your school certified that you are enrolled in 15 credit hours. We sent you a payment of $625.05 for books and supplies."

On November 30th two deposits hit my son's checking acount. The first was for $$6,497.67 for the housing allowance. The second was $625.05 for the books and supplies. We made a payment to the university for his room and board, and left $1,000 in his checking account for expenses and books for second semester.

So, to summarize our benefit:

1. October 13, we receive $3,000
2. Nov 30, we receive two payments, totaling $7,122.72
3. The university received a direct payment of 5,735,25

TOTAL RECEIVED: $15,857.97

All together, it was a slow process, but an incredible benefit to our military family.

Academic Research Suggests You're Paying Your Fund Managers Too Much

A very interesting report on Marketwatch.com reports that index funds beat actively managed mutual funds 97% of the time. This is counter to what some financial planning experts, such as Ray Lucia (of whom I am a huge fan) have said. Mr. Lucia said in a recent broadcast of his syndicated "Ray Lucia Show" that in turbulent times like this, actively managed funds will beat the indexes because of the skill of the fund managers. Unfortunately it's just plain tough to pick a fund manager who's right enough of the time to beat the broader indexes. The other factor is the expense of using mutual funds. Even no-load funds have fees equal to 1% or more of assets invested. Compare this with index funds where the fees are less than 0.3%, and the actively managed funds are already lagging behind index funds. Now try Exchange Traded funds where the cost can be less than 0.17% (plus brokerage fees of course) and you're really swimming up stream with your mutual funds.

Does all this mean that I'm firing all my fund managers? Absolutely not, but for those who argue that the TSP is not a great option because you're linked to broad indexes instead of actively managed mutual funds, this study helps provide a counter-argument.

When it opens, should I fund the Roth or the traditional TSP? Maybe neither!

Let's start with the basics. Dollar for dollar, the money in the Roth Retirement savings account is more valuable than the money in the traditional TSP or 401K. Here's a link to help explain why.

So, all other things being equal, if you can scrape together with $16,500 post tax, the Roth TSP/401K is worth between 25-33% more than the same amount of money in the traditional TSP/401K account because of the taxes.

It's a two edged sword, of course, because you'll have to come up with more money up front because you'll have to pay the taxes now.

When funding retirement savings, conventional wisdom goes like this: Fund your TSP (or 401K) up to the limit of the company match (which of course is $0 for military members), then fund your Roth IRA to the max ($10,000 per married couple) then go back and max out the traditional 401K to the limit ($16,500 in 2010). The Roth IRA allows you to simplify this dramatically. Max out the Roth IRA, then max out the Roth TSP. To do both you'll need to save $2208/mo! That's a lot of clams.

So here's the wildcard: what if you can't save that much? Is it better to have a larger balance growing in a traditional (taxable) 401K or a smaller (post-tax) balance in a ROTH 401K? All other things being equal, it would appear to be a wash--but--current tax laws treat traditional 401K benefits as earned income when computing your taxable portion of your Social Security benefits. It's like getting taxed twice on your money.

So, the bottom line is that as long as you believe that you'll be in a similar or higher tax bracket in retirement, the best plan is max out your ROTH TSP if you can.

Others waffle more than me. but I think this is a solid plan.

The last item to consider is investment choices. Since there's no matching for military members (yet), when the ROTH TSP option becomes available I recommend this plan:

1. Max out your ROTH IRA to maximize your investment options.
2. After you've done that, begin funding your Roth TSP.
3. Once 1 and 2 are complete you can begin to contribute to taxable account using tax advantaged accounts like exchange traded funds.