Your employer might offer you a pension or profit-sharing plan that allows you to sock away pre-tax income. Your employer might also kick in contributions as well. You have to pay taxes when you withdraw money from the plan. If you take money out before age 59 1/2, you might also have to cough up a 10 percent penalty. However, you can make your own annuity and avoid the penalty.
Substantially Equal Periodic Payments
An annuity is a series of payments you receive for a set period or for the remainder of your life. Your pension plan may allow you to invest in an annuity, but you can also set up your own. The Internal Revenue Service allows you to withdraw substantially equal periodic payments from an employer plan or an individual retirement account, even if you're younger than 59 1/2. You avoid the 10 percent early withdrawal penalty if the annual payments continue for a period of at least 10 years, or over your lifetime or life expectancy. You can look up the life expectancy for your age or your age combined with that of your spouse. You then calculate the annuity payments using one of three methods.
Required Minimum Distribution Method
You can figure the annual annuity amount using the required minimum distribution method. The amount is equal to the current account balance divided by the life expectancy for your current age. You can instead use the joint life expectancies for you and your spouse. Life expectancy tables are available in IRS Publication 590. You generally will have a different required distribution each year because of changes to your age, account balance and life expectancy. Nonetheless, the IRS approves this method as a form of substantially equal periodic payments.
Fixed Amortization Method
A second acceptable calculation is the fixed amortization method. Under this method, you figure your annual payment amount once and use the same amount each year. Amortization is a method of dividing an amount into a series of payments. In this case, you use straight-line amortization based on your single or joint life expectancies and an interest rate based on the federal mid-term rate. You can plug these values into a spreadsheet amortization table to calculate your amortization amount. For example, if you’re 50 years old, have a life expectancy of 33.1 years and use an interest rate of 8 percent, the spreadsheet would calculate your annual payment to be $8,679.
Fixed Annuitization Method
The fixed annuitization method also results in a fixed annual payment that remains the same each year. To calculate this amount, you must calculate an annuity factor equal to the present value of a $1 annuity for the chosen life expectancy and interest rate. You can figure this value in a spreadsheet program or on a business calculator. Divide this factor into your account balance in the first year of the substantially equal periodic payments. The result is the fixed amount you’ll withdraw each year.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.