After rolling over my 401(k) into an IRA, I’d like to focus on potentially the single most beneficial reason why everyone should convert their 401(k) into an IRA after they leave their jobs: Rule 72(t).
Rule 72(t) allows for penalty-free withdrawals of your IRA account before the age of 59.5 provided that the IRA holder take at least five “substantially equal periodic payments” (SEPPs). The amount depends on the IRA owner’s life expectancy calculated with various IRS-approved methods.
Three IRS approved methods to calculate SEPP:
1) Required minimum distribution method: This method takes your current balance and divides it by your single life expectancy or joint life expectancy. Your payment is then recalculated each year with your account balance as of December 31st of the preceding year and your current life expectancy. With this method, your payments will change depending on your account value.
2) Fixed amortization method: This method amortizes your account balance over your single life expectancy, the uniform life expectancy table, or joint life expectancy with your oldest named beneficiary. Such a method is more stable.
3) Fixed annuitization method: This method uses an annuity factor to calculate your SEPP. It’s hard enough calculating life expectancy and portfolio performance, let alone forecast interest rates for annuities so let’s skip this method.
The most common withdrawal calculation method is #1. I’d like to use my example for how using Rule 72(t) can help an early retiree extract more income and lead a more comfortable financial life.
TAXES BAD, MORE INCOME GOOD
Situation: Rolled over my 401(k) of 13 years to a IRA in the spring of 2013.
Estimated IRA value: $400,000.
Investment style: Aggressive, but open to be more conservative if I use Rule 72(t).
View on taxes: Hate them!
During my working years, I was unfortunate enough to pay the top federal income tax brackets of 35-39.6%. Given such a high tax bracket, I gladly maxed out my 401(k) every year to save on taxes. Because I earned more than $69,000 ($115,000 income limit if married and filing jointly), I wasn’t allowed to contribute to a traditional IRA sadly enough. For those of you who have such an opportunity to contribute, don’t waste it.
My last full year of 401(k) contribution was for $17,000 in 2012 (you can now contribute a max of $18,000 tax free in 2015). At a 35% federal income tax rate, I was able to save $5,950 in federal income taxes in addition to $1,836 (10.8%) in California state income taxes. The total tax savings by maxing out my 401(k) comes out to roughly $7,786.
Now that I am retired, I’ve managed to get my Adjusted Gross Income (AGI = income after deductions) down to the 25% tax bracket. If I utilize Rule 72(t) based on a minimum distribution method, I can now withdraw from my converted IRA at a 10% lower tax rate (35% – 25%)!
Based on my 401(k) dashboard where I’ve run different retirement scenarios, it states that I contributed roughly $200,000 to my 401(k) over 13 years with the remaining $200,000+ coming from match, profit sharing, and investment returns. To take a conservative approach to tax savings, all I would therefore do is multiply $200,000 in contributions by my tax savings of 10% to equate to $20,000 in less taxes I’ll have paid in my 13 year career. I can also simply take my entire pre-tax retirement fund balance of $400,000 and multiply it by 10% to get $40,000 in tax savings since all of the money may eventually come out.
The bottom line: I’m able to save $20,000 – $40,000 in federal income taxes with Rule 72(t). If I include state income taxes, the savings grows by $6,000 to up to $40,000 if I move to a no income tax state.
SETTING UP THE IRA FOR PERPETUAL LOW TAXED INCOME
Besides the tremendous tax savings I know I will instantly get if I use Rule 72(t), I can potentially also set myself up for a potential perpetual income stream for eternity, or until the world comes to an end! Please read on to find out how.
Consideration: Change investment goal from aggressive capital appreciation to long term dividend aristocrat stocks for income.
Withdrawal calculation: Based on a single life expectancy of 85, I simply take 85 – current age 35 = 50 and divide my IRA value of $400,000 by 50 to get $8,000 a year in withdrawal. $8,000 a year equates to a 2% withdrawal yield on my entire IRA portfolio. Coincidentally, the dividend yield on the S&P500 is also around 2%.
Specific strategy #1: If I dump my entire IRA into the S&P 500 ETF SPY or SDY, the S&P500 Dividend ETF, I could theoretically withdraw $8,000 a year for the rest of my life without reducing much if any of the principal! One can conservatively assume that over the course of 50 years, stocks and therefore my IRA and dividend interest will grow at least the pace of inflation.
Specific strategy #2: Instead of investing my entire IRA into the S&P 500 index SPY, I can focus on a smaller portfolio of higher yielding dividend stocks with dividends all above 3%. Here are some names: AT&T (4.2% dividend yield), HCP (3.5%), Consolidated Edison (3.5%), Legett & Platt (3.3%), Nucor (3.1%), Chevron (3%), Kimberly Clark (3%), Procter & Gamble (3%), Johnson & Johnson (3%), McDonald’s (3%), Clorox (3%). With a blended dividend yield of around 3.4%, I can now withdraw $13,600 a year at a 25% tax rate without ever drawing down principal.
$8,000 – $13,600 a year in dividend income isn’t much, but it’s much more than what I thought I would ever receive before the age of 59.5. It’s good to know that this is a potentially accessible stream of passive income to add to my passive income portfolio.
STARTING RULE 72(t) AT AN OLDER AGE
Age 35 is admittedly a little early to start withdrawing from an IRA using Rule 72(t) as it will take away from maximum compounding. $400,000 is a nice amount, but as we’ve seen in the above calculations, the income stream isn’t very strong. Let’s use three examples which will help reduce the number of years for withdrawal in order to boost the income stream.
Example #1: If I start withdrawing at age 35 with on a 85 single life expectancy estimate, 50 years of withdrawal gives a 2% yield vs. a ~2.2% S&P500 dividend yield. I basically withdraw 100% of what the S&P500 spits out every single year in dividends plus a small 0.2% cushion.
Example #2: If I started withdrawing at age 45 with a 85 single life expectancy estimate, 40 years of withdrawal gives a 2.5% yield based on $10,000 a year divided by $400,000. I’m now slightly over the S&P 500 dividend yield and will probably look to buy the highest S&P 500 dividend yielding stocks via the ETF SDY at the very least.
Example #3: If I start withdrawing at age 55 with a 85 single life expectancy estimate, 30 years of withdrawal gives a 3.3% yield based on $13,333 a year divided by $400,000. This is roughly the maximum I can currently withdraw without spending down the IRA principal.
Example #4: Let’s say I start withdrawing at age 45 with a 95 single life expectancy estimate. This leads back to a 50 year withdrawal level with a 2% yield. On the one hand, living longer increases the likelihood that a IRA portfolio will last forever. On the other hand, you’ll need more money to pay for your life. Hence, it’s better to assume you live longer than the median age and build alternative income streams.
MONEY IS A MEANS TO AN END
I’ve always mentally written off my 401(k), which is now an IRA because I never wanted to depend on government sponsored pre-tax programs to survive in retirement. The same thing goes for social security. This is the reason why I’ve aggressively saved more than 50% of my after tax income every year I worked. If all I had was my 401(k)/IRA in retirement and no other savings or income streams, I’d be screwed because I never planned on working for 37.5 consecutive years after college. I knew after two years on Wall Street that I wanted to retire by 40.
With Rule 72(t), I can now conservatively utilize all my years of pre-tax savings at a 10% lower tax rate to enjoy now. If I maintain a 2% withdrawal rate or less, I should be able to receive $8,000 a year for the rest of my life and potentially pass on the principal to a loved one. The issue I have is that $400,000 just isn’t a significant enough amount of money for me to enact Rule 72(t). I’ve got enough passive income to pay for all expenses and then some. Instead, I would like to try and grow the $400,000 into $1 or $2 million dollars over the next 10 years and then start withdrawing at age 45 or thereabouts.
To grow your portfolio, it’s clearly better to reinvest the dividends into the markets. However, if you are retired, need the income, or don’t plan to live for a long time, utilizing Rule 72(t) is a no brainer. The purpose for all those years of saving for retirement is to actually spend the money in retirement. From a financial standpoint, I can’t think of much worse things than saving for decades only to die without being able to spend your hard earned money.
WEALTH BUILDING RECOMMENDATION
Manage Your Wealth And Cut Investment Fees: If you have a 401(k) or IRA, I highly recommend signing up with Personal Capital and running your portfolio through their free Investment Fee Analyzer tool. I ran my 401(k) through their system and discovered I am paying $1,700 in annual fees I had no idea I was paying! After converting my 401(k) to a rollover IRA, I ran the portfolio through their Investment Fee Analyzer again to see that after some investment changes, I’m now only paying $515 a year. You should do the same exercise.
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About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2016 and beyond.