The recent bear market has not affected all investors equally. Clients who are still working could potentially have years to buy stocks at fire-sale prices. Older retired clients have Social Security checks, pensions in some cases, bond interest and—with good planning—enough of a cash reserve to defer selling their depressed stocks.

Early retirees, however, may be the ones that are hit the hardest. Before age 62, they can't collect Social Security. Further, if they're under age 591/2, they may have to draw down their IRAs, relying on 72(t) rules to avoid early withdrawal penalties.

"In some cases, these early retirees face difficult choices: They can either cut their spending sharply, deplete their IRAs or even go back to work at what is likely to be a much lower salary than they had before," says Bob Keebler, a partner in the accounting firm of Virchow, Krause & Co. in Green Bay, Wis.

Working the Tax Code

Financial planners can help clients make the best of these unpleasant circumstances if they are familiar with section 72(t) of the tax code. In order to avoid a 10% penalty on IRA withdrawals before age 591/2, many early retirees take a series of substantially equal periodic payments (SOSEPP). If they do not maintain SOSEPP for five years or until they reach age 591/2, whichever comes later, all early IRA withdrawals are subject to the 10% surtax.

The IRS has approved three methods for calculating a SOSEPP: amortization, annuitization and minimum distribution. In practice, most people choose either the amortization or annuitization methods, both of which permit relatively large penalty-free withdrawals.

Under the amortization and annuitization methods, the same amount must be taken out every year, Both methods require the taxpayer to choose an interest rate and assume the IRA will grow at that rate. Under the minimum distribution method, payments vary each year, based on changing account values and decreasing life expectancies; this method produces much smaller withdrawals.

Assume 50-year-old James Smith started a SOSEPP in 2005 with a $1 million IRA. "Under the annuitization method, this taxpayer would be taking approximately $60,700 a year from the IRA," says Barry Picker, of Picker, Weinberg & Auerbach, a CPA firm in Brooklyn, N.Y. If the IRA has declined to $600,000 in the 2008 bear market, continuing the required SOSEPP until 2014 would strip approximately $365,000 from Smith's retirement account and might leave less than 25% of the original IRA balance.

What might planners suggest to clients in this situation? There are several solutions.

Pay the Penalty

If Smith doesn't want to shrink his retirement fund, he could stop the SOSEPP and take smaller amounts via a new SOSEPP. However, he already has taken more than $180,000 from his IRA in the first three years.

"Canceling the SOSEPP would result in a penalty of more than $18,000, plus an additional penalty to reflect interest on the penalty for the earlier years," Picker says. "I don't believe it's worth it, and I would not recommend that option."

The situation might be different, though, if Smith were only one year into his SOSEPP, having withdrawn only $60,700 from his IRA. In that case, he might choose to pay a 10% penalty of around $6,000 and set up a new SOSEPP with his $600,000 balance. Paying a relatively small surtax may be an attractive solution for clients who are 57 or 58 years old; if they can minimize ongoing withdrawals for a couple of years, they can tap their IRA penalty-free, once they reach 591/2.

Sustain the SOSEPP

Another option would be for Smith to stay on his original schedule, thus avoiding penalties altogether. This approach may be viable if his IRA has fallen only by 20%, rather than by 40% as in the example above.

"A properly diversified and allocated portfolio may not have declined as much as the broad market indexes," points out Virginia Stanley of REDW Stanley Financial Advisors in Albuquerque, N.M. Her firm's portfolios were down about 20% at the time the S&P 500 was off around 40% from its peak. If Smith's $1 million IRA had fallen to $800,000 instead of $600,000, maintaining the original $60,700 annual distributions would not be as damaging.

What's more, a client whose SOSEPP depletes his IRA does not have to wind up without a retirement fund. "Just because someone has a large distribution doesn't mean he or she has to spend it in the same year," Stanley says. IRA withdrawals can be reinvested in a taxable account.

Clients who are taking a SOSEPP might take the distributions in kind, according to Stanley. "Rather than taking cash from the IRA, transferring securities held in the IRA to a regular account may make sense," she says.