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What is the Annuity Factor Method?

When you invest for retirement, it is advisable to understand the investment world holistically. This includes your contributions, limits, taxes, and withdrawals. If you are contributing to retirement savings accounts like a 401(k), 403(b), or an IRA (Individual Retirement Account), the IRS (Internal Revenue Service) only allows you to take penalty-free withdrawals after the age of 59.5. There are some strict exceptions to this rule. However, if you do not qualify for the exception and wish to take penalty-free distributions from these tax-advantaged accounts, you can use the annuity factor method. The annuity factor method allows you to determine the exact amount of money that can be taken from a tax-advantaged retirement account before incurring penalties.

Here is what you should know about the annuity factor method:

What is the annuity factor method?

As per rules, the IRS only permits penalty-free drawings from tax-advantaged retirement savings accounts like an IRA, 401(k), etc. after you attain the age of 59.5. The annuity factor method is a method that helps people opting for an early retirement or anyone requiring early withdrawals from retirement accounts access their retirement funds without incurring any penalty before the official age of 59.5.

The annuity factor method is one of the three methods that are most widely used to determine duty-free withdrawal amounts. These include:

  • The Required Minimum Distribution Method (RMD)
  • The fixed amortization method
  • The fixed annuitization method (or the annuity factor method)

All three approaches use the life expectancy of the retiree or the mortality table. The amortization method and the annuitization method ask you to also specify an acceptable rate of interest.

How does the annuity factor method work?

The annuity factor method or the fixed annuitization method is similar to the fixed amortization approach but uses a slightly different data set. The annuity factor method divides your account balance (IRA, annuity, etc.) by an annuity factor.

The annuity factor is obtained from the IRS average mortality table (IRS Ruling 2002-62 Appendix B) to specify the annual payment sum. In financial terms, the annuity factor is the current value of a payout of $1 per year per the number of years of your life expectancy, based upon the mortality table and a reasonable rate of interest at the time when the distributions begin. As of 2020, the annuity factor method calculations can use an interest rate of less than 120% of the mid-term applicable federal interest rates.

Once you determine the annuity factor amount, you cannot change it before five years. The same annual distribution must be given out until the five subsequent years or once you reach the age of 59.5, whichever comes later. Moreover, even though the annuity factor approach is the most complex out of the three penalty-free calculating methods, it also offers the highest payments. You can choose to receive your drawings annually, quarterly, or monthly. However, you have to ensure to keep taking the withdrawals. In case the withdrawals are disturbed, all the funds taken out previously become subject to early withdrawal penalties. Further, you must understand that the annuity factor method can help you get penalty-free drawings from your retirement accounts or annuities, but you would still be liable to pay the applicable income tax on the sum taken out.

What are the reasons for early withdrawals?

There are several reasons why you could need early distributions from your retirement savings plans and hence, use the annuity factor method to determine the precise amount of each withdrawal. You could need early withdrawals in the following situations:

  • You opt for early retirement and do not have substantial savings or other sources of income apart from your retirement accounts or annuities.
  • Your account has grown substantially, leading you to fall in a higher tax bracket before the age of 59.5.
  • You do not fit in the IRS early withdrawal exceptions but need the smaller payouts to fulfil urgent expenses. This is more applicable for small business owners and executives who get specific shares of company stock or some stock options as a qualified plan.
  • You are young and far away from retirement but wish to buy growth stocks to eventually fill a large part of your retirement accounts.

What are the benefits of an annuity factor method?

  • There are several advantages of using an annuity factor method. Some of the significant ones include: This method usually allows payments that are large enough and also last long to provide adequate income until your other qualified distributions (on different retirement accounts) begin after the age of 59.5.
  • By using this method, you can get penalty-free distributions from your qualified retirement plan.
  • If these early distributions are your only source of income, you could be at a lower tax bracket as compared to the time when the actual income was earned.

How does the annuity factor method fare against the other two approaches?

All three approaches – annuity factor, fixed amortization, and RMD – are approved by the IRS to calculate penalty-free distributions from the retirement savings accounts. However, each method differs from the other in terms of its base calculation and parameters included.

  • RMD: This is the easiest method of all the three. The total account value is divided by life expectancy. The life expectancy is based on single life, uniform life, joint life, and last survivor, according to the attained age in the year of the distribution calculation.

  • Fixed amortization: This method allows you to amortize the value of your concerned retirement account over life expectancy by applying an appropriate rate of interest (up to 120% of the mid-term rate).

All three methods can be better compared with the help of an example:

For example, consider a scenario where you are 50 years old, and own an IRA from which you would like to take early distributions at the beginning of 2020, without incurring the 10% penalty. You can take advantage of the substantially equal, periodic payment exception, as per the IRS, and use any of the three methods to calculate your actual amount for penalty-free withdrawals.

  • Your account balance is $400,000 on December 31, 2019 (last valuation).
  • 120% of the reasonable federal mid-term rate is considered to be 2.98%.
  • You will use single life expectancy factors.

Under the RMD method:

For 2020, your annual penalty-free distribution is calculated by dividing the December 31, 2019 account balance with the life expectancy factor (as obtained from the IRS Uniform Lifetime Table).

So, $400,000/34.2 = $11,696

For the subsequent year, the account balance of the previous year will be considered, and the life expectancy factor will differ as per the age but from the same IRS table.

Under the fixed amortization method:

For 2020, your annual penalty-free distributions by the amortization method will be calculated by amortizing your December 31, 2019 balance ($400,000) over several years, equalling it to your life expectancy factor (34.2), at the assumed reasonable interest rate (2.98%).

So, this will equal $18,811.

Under the annuity factor method:

For 2020, as per the annuity factor method, your annual penalty-free distribution will be calculated by dividing your account balance ($400,000) by the annuity factor. At the age of 50, the annuity factor is 21.345 as per the IRS mortality table, with a reasonable interest rate of 2.98%. So, this will be equal to $18,740.

Conclusion

In all, each method gives a different annual distribution limit. The choice ultimately depends on your financial requirements and tax objectives. That said, the IRS allows you to switch from one method to another only once, so be careful to make the maximum use of this privilege. You can also consider consulting a professional financial advisor to use the best method as per your financial situation.

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