If You Tap Your IRA Early, Avoid These Costly Mistakes

Hi, Gail-

A couple of years ago (2005) I lost my job and needed money to pay expenses. At the time I was 52-years-old and had about $350,000 stashed in my IRA because I’ve always rolled over the money in my retirement plan when I changed jobs. I figured that would be a good source for the cash I needed so I called my IRA custodian. They said because I wasn’t 59-and-a-half-years-old, the only way I could avoid a penalty on this was to take out a set amount each year, so that’s what I started doing.

As it turned out, I found a new job — for more money (!) — faster than I thought (who says this is a bad economy?). Since I don’t need the money from my IRA, I’d rather it stay in the account and grow so I’ll have it for my retirement.

Plus, I’ve started taking a closer look at the returns I’m getting and, frankly, I think I could do better elsewhere.

So here are my questions: Can I stop my IRA withdrawals? Is there any way my current IRA custodian can prevent me from moving my IRA someplace else?


Dear Audrey,

My recommendation can be summed up in a single sentence: Do NOT change a thing!

Your IRA custodian is correct: anyone under age 59-and-a-half who takes a withdrawal from their traditional IRA will pay a 10 percent penalty in addition to the regular income tax owed.

However, there are a number of exceptions, including becoming disabled or using the money to pay college tuition for yourself, your spouse, or your child. (1) The final exception is a catch-all, that is, if your reason for needing the money isn’t specifically covered, you can avoid the 10 percent early withdrawal penalty by only withdrawing a certain amount each year.

It’s important to understand that you don’t get to decide what this amount is. The I.R.S. lays out three ways you can calculate these so-called “substantially equal periodic payments,” or SEPPs.(2) (I know the description is a bit strange. However, while you and I consider these withdrawals, the I.R.S. perspective is that the IRA is making payments to you.)

You also don’t get to decide how long you are going to take these distributions. The rule is that once you begin withdrawing money under the SEPP rules you cannot stop until one of the following occurs: a) you reach age 59-and-a-half, or b) 5 years have passed — whichever takes longer.

Unfortunately, since you began taking SEPPs at age 52, you must continue doing so for 7 years, i.e. until you reach age 59-and-a-half.

With regard to your second question, the Tax Code makes it very clear that you don’t want to mess around with an IRA from which you are taking early withdrawals. If you “modify” the amount you are withdrawing before the timetable (explained above) is up, you will be assessed the 10 percent penalty, plus interest retroactive to the first dollar you received.

Several Private Letter Rulings have underscored the fact that the I.R.S. takes this issue very seriously. In a decision handed down five years ago, the I.R.S. said that transferring all or part of your IRA to a different custodian while you are in the midst of taking SEPPs is considered a “modification.” (3)

It’s extremely important to keep track of the exact date on which your withdrawals began because this is what determines when the 5-year period has been completed. A taxpayer who thought he had followed the letter of the law found out the hard way.

This individual started taking early withdrawals from his IRA on a quarterly basis, which is allowed. He calculated the amounts correctly and took every withdrawal on time, the last one being October 1, 2005.

The problem arose because he had left the employer he was working for in June 2005. He instructed the administrator of his company retirement plan to transfer his account balance to his IRA. This finally occurred on October 22 — after he had taken his last required SEPP.

However, because the 5-year period was technically not completed until January 21 2006, the I.R.S. ruled that his IRA had been “modified.” He was hit with a 10 percent penalty plus interest on all of the distributions he had taken since the SEPP began!

“He thought he was done since he had taken the last payment,” says C.P.A. Ed Slott. “As long as you’re taking the right amount out, why does the I.R.S. care?”

Indeed. But the fact of the matter is, they do care — very much.

The lesson: If you’re taking withdrawals under the SEPP provision of Section 72(t), do nothing that affects the balance in your IRA. If you do, the penalty will apply retroactively to the first dollar withdrawn.

Slott, who has authored several books on how to avoid IRA pitfalls, says, he tells people under the age of 50 not to use substantially equal period payments to access IRA assets. “The longer you have to take withdrawals,” he says, “the greater the chances you’re going to screw something up.”

If you really need to get your hands on cash, Slott recommends taking out a home equity loan instead of tapping your IRA. After all, the latter simply reduces the amount of income you’ll have later (when you retire) so you can have it sooner.

In other words, draining your IRA should be a last resort. If that’s the only choice you have, in Slott’s opinion, consider not using SEPPs. He feels you’re better off if you “take a lump sum payment, pay the 10 percent penalty, and be done with it.”

The IRA regulations are deceptively complex. This is definitely an area where a little bit of knowledge can be a dangerous thing. Thinking logically can get you into deep, deep trouble!

Hope this helps,

1.For a complete list, see Section 72(t) of the Internal Revenue Code.

2. See Section 2.02 of Revenue Ruling 2002-62.

3. PLR 2002-62. See also 2007-20023.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.