If you need to withdraw funds from an individual retirement account or 401(k) account before age 59 1/2, there’s usually a 10% early withdrawal penalty. However, an IRS rule known as rule 72(t) waives the 10% penalty on some early retirement plan withdrawals if you take the distributions in a specific way.
IRS Rule 72(t) allows early retirement plan withdrawals with no 10% penalty if several qualifications are met:
— As long as retirement plan-holders abide by the rules, funds can be withdrawn for any reason.
— All retirement plan withdrawals must adhere to strict IRS guidelines.
— Plan distribution amounts cannot be adjusted for inflation.
— Funds that are withdrawn from a traditional retirement account are taxable.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
What Is Rule 72(t)?
Rule 72(t) allows retirement account owners to make penalty-free withdrawals before age 59 1/2 if they take the distributions in a specific way. “Rule 72(t) allows retirement account holders to set up regular withdrawals — defined as substantially equal periodic payments by the Internal Revenue Code — over the course of five years or until they turn 59 1/2, whichever is longer,” says Mindy Yu, director of investing at Betterment at Work in New York.
Most exceptions to the early withdrawal penalty require that the money be used for a specific purpose, but funds withdrawn via rule 72(t) do not require a specific reason. “Usually, withdrawals for younger people are limited to very few exceptions, such as medical emergencies, college tuition or other such hardships,” says Wayne Brown, a partner at Dugan Brown, a retirement planning firm in Columbus, Ohio. “72(t), however, provides a rigid set of steps that one can take in order to begin using funds for any reason they want, so long as one closely adheres to the rule.”
How the 72(t) Rule Works
To take advantage of the 72(t) rule, a retiree must meet certain qualifications. “While you can schedule several SEPP distributions a year, you must take at least one a year for five consecutive years or until you turn 59 1/2,” Yu says. “Once distributions begin, the series of payments cannot be modified or a 10% early withdrawal penalty will be imposed retroactively, starting with the first year of distribution.”
You also can’t use the rule to take distributions from a retirement account associated with an ongoing job. “You’re not allowed to withdraw from retirement accounts managed by your current employer, as they’re not eligible for SEPPs,” Yu added.
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
How to Calculate Distributions Under Rule 72(t)
Payment amounts must follow IRS guidelines. Rule 72(t) payments can be based on one of the following options:
Required minimum distributions. Under this approach, required minimum distributions are calculated annually by dividing the distributable balance by the life expectancy listed on an IRS life expectancy table selected by the investor. “These tables are based on uniform lifetime, single life expectancy or joint and last survivor life expectancy,” says Benjamin Koval, a certified financial planner and founder of SoundPath Retirement Strategies in Bellevue, Washington. “This method typically yields the lowest monthly payment.”
Fixed amortization. This approach amortizes the distributable balance based on the selected life expectancy table and IRS-approved interest rate. “Once initially determined, the annual payment amount stays constant for each successive year,” Koval says.
Fixed annuitization. This method determines payments by dividing the distributable balance by the IRS’s published annuity factor applicable to the investor’s (or investor’s and beneficiary’s) current age. “Once determined, the annual payment amount applies to each future year,” Koval says.
Once the payment method, size and frequency of payments (annually, quarterly or monthly) is decided, the individual is essentially locked into drawing those substantially equal periodic payments for five years or until they turn age 59 1/2, whichever takes longer. “Deviating from the predetermined SEPP amount would result in that person suffering a 10% IRS penalty on all payments, even applied retroactively to the withdrawals taken before the deviation occurred,” Brown says.
Pros of Using Rule 72(t)
Rule 72(t) allows younger investors access to their retirement money. “They can do so without incurring the early withdrawal penalty,” Koval says. Investors can also spread taxation of the distributable balance over a long period of time. “This can help reduce tax costs,” Koval says.
The 72(t) rule provides early access to an individual’s retirement savings that he or she otherwise wouldn’t be able to leverage without meeting the specified exceptions. “When there are unexpected financial situation changes, there is additional flexibility to tap into retirement funds you otherwise wouldn’t be able to access,” Yu says. “However, these withdrawals come with strict contingencies and financial consequences if you fail to meet the requirements.”
Cons of Using Rule 72(t)
Rule 72(t) offers little flexibility to change your payment schedule later. With the exception of a one-time option to convert from the amortization or annuitization method to the required minimum distribution method, “the Rule 72(t) election cannot be modified or terminated without incurring early withdrawal penalties for all distributions taken before age 59 1/2,” Koval says.
Distribution amounts cannot be changed to offset the effects of inflation. A Rule 72(t) election “represents a long-term commitment that reduces the investor’s flexibility in responding to future changes in their financial situation,” Koval says.
The process of calculating distribution methods or seeking financial advice to help set up the distributions can also be burdensome. “In addition, since you’re withdrawing from funds that have never been taxed, they are still subjected to your normal income tax rate,” Yu says. “Therefore, withdrawals should only be considered as a last resort when you have exhausted all other options to mitigate financial burdens.”
How to Decide if You Should Take Rule 72(t) Distributions
In general, leveraging Rule 72(t) election depends on the retirement age of the investor, their need for income, their tax bracket and the availability of income from other sources. “For many investors who retire at age 55 or later, the IRS ‘rule of 55’ provision allows penalty-free distributions from the prior employer’s 401(k) or 403(b) plan,” Koval says. “This provides greater flexibility compared to a rule 72(t) distribution.”
More from U.S. News
10 Important Ages for Retirement Planning
9 Ways to Avoid the 401(k) Early Withdrawal Penalty and Other Fees
10 Tax Breaks for People Over 50
What Is Rule 72(t)? originally appeared on usnews.com
