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Early Retiree Tax Rules Eased

Finances: Government won't penalize those who alter withdrawal rates for 401(k) or IRA plans hurt by market losses.


The federal government said Thursday that it has relaxed tax rules that penalize thousands of early retirees whose savings have been slammed by the bear market, but stopped short of providing the same help to millions of older retirees who complain that they suffer from much the same problem.

"Taxpayers have worked hard to build their retirement savings. They shouldn't be penalized when the market is down," Pamela Olson, assistant Treasury secretary for tax policy, said in a statement.

The change, effective immediately, eliminates tax penalties for early retirees who want to slow their rate of withdrawal from qualified retirement plans such as 401(k)s and individual retirement accounts before they are 59 1/2.

"In all the previous rules and regulations, the possibility that a retirement account balance could decline from year to year was never even considered," said Ed Slott, a retirement tax expert in New York. "But in the past couple of years, people's retirement balances have not just been declining, they're in a free fall. This ruling has been long awaited."

Analysts say the effect of the declining market has hit early retirees--whose numbers are estimated in the tens of thousands--particularly hard. That's mainly because early retirees who want to tap into qualified plans were forced to make an irrevocable decision when they retired that spelled out just how much they would withdraw each year.

All the formulas retirees could choose from assumed the accounts would continue to earn investment returns. The declining market wrecked those plans, and withdrawal rates set in good times are now threatening to empty the plans prematurely. But early retirees were prohibited from changing the withdrawal without triggering a 10% retroactive tax penalty that could run into the thousands of dollars.

The new rule allows early retirees to change their withdrawal amount, without penalty, and calculate the right amount based on the current value of their account. It also makes clear that the Internal Revenue Service won't further penalize retirees who stop making withdrawals for the simple reason that the value of their account has dropped to zero.

"They're capping your losses at 100%," Slott said. "That may not sound good, but it's an improvement."

The new rules don't address the concerns of millions of older retirees who say they're also penalized by tax rules that force them to take money out of their accounts based on a formula that could prematurely deplete them.

"I have exactly the same problem," said Gerald Shearer, a retired engineer who lives in Orange County.

"I have to take out twice as much from my retirement plan as I should if I were basing the withdrawal on my current account balance."

Treasury officials said Thursday that they had no plans to review mandatory withdrawal regulations for those who are older than 70 1/2.

"We just finalized those regulations," said William F. Sweetnam, benefits tax counsel for the Treasury.

"In [those rules], there is always going to be a lag. If the value of your account goes down, you are stuck making [bigger withdrawals]. But if it goes back up the following year, you can make a smaller withdrawal. It's just a timing difference."

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