Let’s say that you’ve done an exceptional job saving for retirement over your career and want to retire early. Or maybe you’re in a tough financial spot and are considering a withdrawal from one of your retirement accounts. In each case, there’s one catch – if you’re not 59-1/2, you’ll owe a 10% penalty on any withdrawals. So, how can you access your retirement funds without paying the penalty? That’s where Rule 72(t) can come into play.
What Is Rule 72(t)?
Rule 72(t) refers to IRS Code Section 72, Subsection T. It’s a section of the Internal Revenue Code that outlines a way to make early withdrawals from retirement accounts without being subject to the normal 10% penalty. If you retire before age 59-1/2, you can still access funds from your IRA, 401(k), or 403(b) using Rule 72(t).
Rule 72(t) can be used at any time with an IRA account. For the rule to be used with an employer retirement plan such as a 401(k) or 403(b), the plans can no longer be active. You must separate from service before you can access those funds in this way.
Substantially Equal Periodic Payments
As you would expect, in order to avoid the penalty, you’ll have to abide by a few rules. To access your retirement funds early, the Internal Revenue Code specifies that you must withdraw them in “Substantially Equal Periodic Payments”, or “SEPPs” for short. SEPPs are simply a series of scheduled withdrawals. The frequency of these withdrawals must occur at least annually and continue for five years or until you turn 59-1/2, whichever comes later.
It’s important to abide by these rules. If you skip an installment, you’ll owe the 10% tax penalty – and interest – on all the withdrawals you’ve made up to that point.
There are three different methods for calculating SEPPs:
- By using your Required Minimum Distribution (RMD),
- The Amortization method, and
- The Annuitization method.
With the Required Minimum Distribution method, you’ll divide your year-end account balance by a number found in a life expectancy table in order to determine what your payment will be for that year. This is essentially the same way that your RMDs are calculated later in retirement. Each year, you’ll recalculate your withdrawal using the same method.
The amortization method is a little more complex. Here, you create an annual withdrawal schedule based upon your most recent account statement balance. You assume a reasonable interest rate (not to be higher than 120% of the mid-term Applicable Federal Rate) to create an annual payout based upon the appropriate life expectancy table.
Finally, the annuitization method works just like an annuity, as you would expect. You take your most recent account statement balance and divide it by an annuity factor found in the mortality table specified by the IRS.
Where the amortization and annuitization methods will result in equal withdrawal amounts, the RMD method does not. There may be advantages or disadvantages to each, depending upon your needs. Outside of these three methods, there are no other ways to customize your withdrawal amounts.
If you find you need withdrawal amounts that are greater or less than the withdrawals available through these three methods, you can always roll funds into (or out of) your IRA prior to starting your SEPPs. However, once you’ve started your withdrawals using Rule 72(t), you’re not allowed to make changes.
Once you’ve chosen the method, you’re required to continue the withdrawals for five years or until you reach age 59-1/2, whichever comes later. It may be helpful to use an online calculator to assist you, especially when it comes to choosing the right life expectancy table.
When to Use Rule 72(t)
Typically, Rule 72(t) shouldn’t be your first option to access retirement funds. Using the Rule of 55 to withdraw funds from tax-deferred accounts is preferable if it’s available. There also may be other ways to access retirement funds penalty-free in certain circumstances. Among these exceptions are medical expenses, health insurance, disability, qualified higher-education expenses, and a first-time home purchase.
If none of these other routes are available to you, Rule 72(t) can be useful. Back to our original example, if you’ve saved profoundly, setting up Substantially Equal Periodic Payments can allow you to retire before age 59-1/2 and access your funds without penalty. There’s no need to be punished for doing a great job of saving.
At the other end of the spectrum, Rule 72(t) can be helpful in the case of a financial emergency. If you’re in a situation where your IRA is the last resort, Rule 72(t) can at least help you avoid the additional 10% penalty. You’ll still have to pay the taxes on the withdrawals, of course, but you can still access your IRA funds in a pinch.
Use Caution with Rule 72(t)
No matter what your situation, always consult with your CPA before initiating Rule 72(t) SEPPs. You’ll still need to pay income taxes on whatever comes out of your retirement accounts. Given the limited options available regarding the amounts and frequency of distributions, it’s a great practice to hire a CPA to walk you through the tax implications.
I should also point out that some of the protections afforded to retirement accounts in bankruptcy would no longer apply to anything that’s been withdrawn using Rule 72(t). If you’re accessing these funds due to financial hardship, once the funds have been withdrawn, they would no longer be protected in bankruptcy.
When it comes to pre-age 59-1/2 withdrawals, Rule 72(t) isn’t the only game in town. The Rule of 55 is much simpler and more flexible. If that’s an option available to you, start there before exploring Rule 72(t). I recommend you read my prior blog post that shows you how to access retirement funds using the Rule of 55.
If you need help creating a withdrawal strategy in retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.