72(t) Distributions: Is it Right for You?
Under normal circumstances, withdrawing funds from IRA or qualified retirement plans (e.g., 401(k), 403(b), 457, etc.) before the age of 59 ½ will result in a 10% early withdrawal tax penalty. However, the IRS does permit you to avoid the 10% penalty under Rule 72(t). In this blog, we will go over how this rule works and who may benefit from it.
Under this IRS code, the account owner must withdraw funds under a schedule of Substantially Equal Periodic Payments (or SEPPs). A SEPP schedule requires you to follow a few rules:
- You must make annual, equal payments from the account for at least five years or until you turn 59 ½, whichever comes later. If a single payment is missed, you will owe the 10% early withdrawal penalty on all the funds that have been withdrawn under this SEPP schedule.
- Ordinary income taxes must still be paid from these withdrawals.
- For those looking to setup a SEPP schedule from retirement plans, you must first separate from service before setting this up.
Since you do not have the freedom to choose how much to withdraw, the IRS provides three options to determine how much can be withdrawn on an annual basis:
- The Minimum Distribution Method: Like Required Minimum Distributions for individuals age 72+, the IRS has a special age-factor table to calculate your withdrawal. This age-factor serves as the divisor for the calculation. Dividing your prior-year end balance by this age-factor will determine your distribution for the year. Under this method, you would have to recalculate your withdrawal each year, likely resulting in a lower year-to-year withdrawal in contrast to the other methods.
- The Amortization Method: This method calculates annual withdrawals by amortizing the balance of your IRA over the life of the SEPP schedule. Determining your age-factor in conjunction with the IRS’ Applicable Federal Rate (a special rate setup for various tax purposes) are required for your monthly payments. This method generally allows you to withdraw the largest amount from the account in contrast to the other methods.
- The Annuitization Method: This calculation involves dividing the account balance by an annuity factor provided by the IRS, thus resulting in a fixed payment over the life of the SEPP schedule.
Once the withdrawal amount is determined, it usually cannot be changed. Due to this, individuals who experience increases in the account balances, may face larger distributions over time. In such a situation, you are allowed a one-time withdrawal option change, but only from either the Amortization method to the Minimum Distribution method or the Annuitization method to the Minimum Distribution method.
Is This for You?
Understanding and calculating SEPP schedules can get complicated quickly. As mentioned above, missing a single payment will result in you owing the 10% penalty on all previous distributions. There are other options that will allow you to avoid the 10% early withdrawal penalty (i.e., medical expenses, disability, first-time home purchase, etc.). 72(t) distributions should be considered as a last resort for most people. Consulting with a fee-only financial advisor can help you determine the best option for retirement funding.
Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.