Rule 72(t)

Breaking Down Rule 72(t): How to Access Your Retirement Funds

Rule 72(t) allows you to access your retirement savings without penalty before age 59 ½. But, although the rule provides flexibility to tap into retirement accounts you otherwise wouldn’t be able to access, it’s like signing a deal with the devil. Once you sign up, there is no getting out, and you must navigate the precise guidelines to a T, as in Rule 72(t).

What Is Rule 72(t)?

Rule 72(t) is the section of the Internal Revenue Code outlining early withdrawals from qualified retirement accounts. Your qualified retirement accounts have outstanding tax benefits along with a restriction from withdrawals before 59 ½ or age 55, should you qualify for that exception. Should you withdraw funds before then, the IRS may impose a 10% penalty on the withdrawn amount unless an exemption applies. Visit the IRS for a comprehensive list of exceptions to the 10% tax on early distributions. 

If none of these exceptions apply to you, Rule 72(t) lets you establish a schedule of distributions from your retirement account called substantially equal periodic payments (SEPPs).

What Are SEPPs?

SEPPs are annual retirement plan distributions made over five years or until you turn 59 ½, whichever is longer.

Qualified retirement plans eligible for Rule 72(t) include 401(k), 403(b), 457(b), Thrift Savings Plans (TSPs), and IRAs.

Using Rule 72(t) to set up a schedule of SEPPs is not a simple process, and there are several critical rules to follow:

  • Payments must be annual. Each year, you must withdraw the calculated SEPP amount without fail. Remember, it must be for five years or until you turn 59 ½, whichever is longer.
  • Payments must be precise. If you mishandle SEPPs, you’ll be on the hook for the 10% IRS early withdrawal penalty not just on one year’s distributions but all previous ones.
  • You must pay income taxes on IRA or 401k withdrawals. Distributions are taxed as income. 
  • Try not to apply Rule 72(t) to your Roth IRA! Roth IRAs lose their tax-free benefit with Rule 72(t), and you must pay income tax on investment earnings withdrawn from Roth accounts. That defeats the purpose of a Roth IRA. Do not use a Roth IRA for Rule 72(t) unless this is the absolute last resort for cash.
  • Be careful if you’re still employed. Rule 72(t) does not apply to your employer’s retirement account if you’re still working.  

How to Calculate SEPPs under Rule 72(t)

We mentioned that the payments must be precise. Step one is calculating SEPPs under the 72(t) rule to determine which of the three IRS life expectancy tables applies to you.

  • The Uniform Table applies to unmarried account holders, married account holders whose spouses are 10 years younger or less, or those whose spouses aren’t the sole beneficiaries of their accounts.
  • The Joint and Last Survivor Expectancy Table applies to account holders whose spouses are more than 10 years younger and are also the sole beneficiaries of the account.
  • The Single Expectancy Table applies the single life expectancy of the taxpayer.

Once you have your table, step two is deciding which of the three SEPP calculation methods is best for your circumstances. 

  1. Minimum distribution.
  2. Amortization.
  3. Annuity method.

Each method will produce slightly different annual withdrawal amounts.

The Minimum Distribution Method

The minimum distribution method for calculating SEPPs under Rule 72(t) works similarly to determining required minimum distributions (RMDs). It yields the lowest possible withdrawal requirement of the three methods.

Divide your account balance by the number of years the IRS expects someone your age to live using the appropriate life expectancy table from the abovementioned options.

The resulting figure is the amount you must withdraw in year one of your SEPP. This amount is recalculated for the five years, giving you different minimum distributions each year.

The Amortization Method

The amortization method calculates fixed annual SEPP payments that remain the same over the five-year withdrawal period, with no need to recalculate distributions each year.

To determine the annual amortization payment, select the appropriate life expectancy factor and federal mid-term rate, a special rate the IRS sets for various tax purposes. For the amortization and annuitization methods below, you must look up the monthly federal mid-term rate to calculate SEPP withdrawals.

The Annuity Method

The annuity method calculates a minimum SEPP withdrawal that remains fixed over five years. It works by factoring your total account balance, an annuity factor provided by the IRS, the federal mid-term interest rate, and the account owner’s life expectancy.

Finally, when the table and method are decided, you are practically locked into drawing those substantially equal periodic payments for five years or until they turn age 59 1/2, whichever takes longer. Differing from the predetermined SEPP amount will result in a 10% IRS penalty on all payments, even applied retroactively to the withdrawals taken before the deviation occurred.

You can elect a one-time irrevocable switch to the RMD method from the amortization or the annuity factor method. 

Should You Use Rule 72(t)?

Rules 72(t) comes in handy in two instances.

  1. If you are facing a financial emergency and have exhausted your other options for obtaining cash, using 72(t) to access your retirement funds might be worth considering. Remember, SEPPs can damage your retirement plans by eliminating future investment growth.
  2. If you want to retire before 59.5, have enough saved but not enough non-retirement account savings.

How to Decide if You Should Take Rule 72(t) Distributions

In general, leveraging Rule 72(t) election depends on your retirement age, need for income, and the availability of income from other sources. If you retire at age 55 or later, the rule of 55 allows penalty-free distributions from your employer’s 401(k)/403(b). This provides greater flexibility than a rule 72(t) distribution.

Other essential points regarding Rule 72(t)

  1. 72(t) payments can begin at any age before 59 1/2.
  2.  The 72(t) payment plan only applies to the IRA or IRAs from which you calculated your initial payment. You can use the splitting strategy before setting up a 72(t). Split your IRA into two—one IRA to calculate 72(t) distributions and one for later.
  3.  You cannot add funds to your Rule 72(t) account. That includes rollovers or contributions. Any change in the account’s balance other than investment gains and losses or 72(t) distributions is considered a modification, and the 10% penalty will be triggered. 
  4. You cannot roll over your 72(t) payments to another IRA.
  5. You cannot convert your 72(t) distributions to a Roth IRA.

Get Help Calculating Rule 72(t) SEPPs

Committing to Rule 72(t) is a significant and complex decision. Choosing the right approach can get complicated quickly. Any mistakes can incur expensive IRS penalties. If you’ve evaluated your options and decided to use Rule 72(t) and SEPPs, consult with a fee-only Certified Financial Planner®, Professional (CFP). 

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