How to Tap Retirement Assets Early With a Minimal Tax Bite

Unemployed and strapped for cash?

Your retirement plan may look tempting as a source of new money, especially when you're out of work. But taking money out of a retirement plan subjects you to enormous tax penalties that can cut your savings in half, so most advisors say it makes sense only as a last resort.

But if you must, the key is to tap retirement money carefully to reduce the tax hit.

"There's an overriding misconception that there's an exception to the tax penalties for financial or economic hardship," said Ed Slott, a New York accountant who is an expert on retirement plan rules and pens a monthly newsletter called Ed Slott's IRA Advisor. "There is no exception. You can't take money out of a retirement plan penalty-free just because you lost your job."

That said, there are ways to avoid tax penalties. And avoiding penalties is important because they zap more than 10 percent of your savings. Withdraw $10,000, and $1,000 in penalties are due to Uncle Sam.

Many state tax authorities impose additional levies. California, for example, will eat up a further 2.5 percent of the withdrawn amount. So that $10,000 gets whittled down to $8,750 -- and that's before you pay regular income taxes to both the state and federal governments, which are always required on retirement withdrawals.

There are several ways to get at least a portion of your retirement money out without paying penalties. But there's just one method that works for all types of retirement plans -- the "substantially equal periodic payments" or "the 72(t)" method of retirement withdrawals. Section 72(t) of the tax code spells out the rules for penalty-free early retirement plan distributions. Accountants, being clever wordsmiths, thus call these penalty-free early withdrawals "72(t) distributions." To be fair, there's no snappy way to say it.

How does it work? In a nutshell, you spread out your retirement payments over your remaining life span, taking "substantially equal" annual payments for the rest of your life.

You can actually stop taking payments -- or boost your payments -- after age 59 1/2 . But any amount you take out before you hit that magic age must be based on the formula and cannot change from year to year.

The catch? There are three.

First, it's complicated to figure out how much to take because there are three ways to calculate the right amount and the more complex of these often provides the most generous annual payments.

Even IRS Publication 590, which attempts to explain how to do these withdrawals correctly, says that two of the calculations shouldn't be attempted without professional help.