Money Before 59½: 72(t) Distributions

Sometimes it feels good knowing you can withdraw money from a retirement account before age 59½ without having to pay the pesky 10% penalty. I’d wager to guess that most people would contribute more money to retirement accounts if they knew there were ways to get access to the money early.

One of the ways to access money early is setting up a Roth IRA Conversion Ladder. To briefly recap, to set up a Roth IRA Conversion Ladder you slowly convert a Traditional IRA (the kind of account you’d have after you quit a job and rolled your work’s 401(k) over to personal account) into a Roth IRA. If you do the conversions during a period of low income you can skip or reduce the amount of taxes you’ll pay too. Once you convert, you’ll wait five years and then be able to withdraw the converted amount without penalty from your Roth IRA.

Another “hidden” way to access money from a retirement account without paying the 10% penalty is through 26 U.S. Code §72(t). This method is a little more complicated but with the help of qualified professional tax/financial advisor should be pretty easy.

What is the 72(t) rule?

First, let’s look at the IRS FAQ on §72(t):

An additional 10% tax applies to early distributions (before the participant reaches age 59½) from a retirement plan or IRA under Code §72(t)(1). Section 72(t)(2) lists exceptions to this tax, including distributions received in substantially equal periodic payments.

Sounds great, right? All we need to do is figure out the Section 72(t)(2) exceptions. More from the FAQ:

If distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary, the §72(t) tax does not apply. If these distributions are from a qualified plan, not an IRA, you must separate from service with the employer maintaining the plan before the payments begin for this exception to apply. If the series of substantially equal periodic payments is subsequently modified (other than by reason of death or disability) within 5 years of the date of the first payment, or, if later, age 59½, the exception to the 10% tax does not apply.

Translation: If you meet a few requirements (discussed below) you can withdraw money from a retirement account prior to age 59½ without paying the 10% penalty (of course, you’ll still have to pay ordinary income tax).

For an investor intending to retire before 59½ this could play a big role in accessing retirement funds early.

How do you implement the 72(t) rule?

To avoid the 10% penalty, 72(t) requires the investor to take annual distributions from a retirement account that are “substantially equal periodic payments” (SEPPs) calculated to distribute the entire balance of your IRA over your remaining life expectancy.

After you begin taking 72(t) distribution, you must continue taking such distributions for 5 years or until you reach 59½, whichever is longer.

In other words, once you begin taking these distributions you’re locked in for several years. There’s no way to change your mind unless you are willing to pay the penalties and interest.

After you reach 59½ (and so long as you’ve been taking payments for 5 years) you can stop taking annual SEPP distributions.

By taking 72(t) distributions you’re effectively creating an annuity out of your retirement account by calculating distributions based on your life expectancy.

How much can you take out each year?

There are three ways to calculate your annual SEPP distribution. You can run the calculations for each method and choose the one that fits your income requirements and tax planning needs.

1. The Required Minimum Distribution Method,
2. The Fixed Amortization Method, and
3. The Fixed Annuitization Method.

Here’s a simple calculator from Bankrate to show you how much you can withdraw based on a few assumptions: 72(t) Distribution Calculator.

Let’s run through an example.

Example. Larry, 42, has a portfolio of $1,500,000 in a retirement account. He wants to start taking SEPP distributions using Rule 72(t). According to the Bankrate calculator, he can withdraw $35,971 using the required minimum distribution method or up to $56,919 using the fixed amortization method.

Using the 4% Safe Withdrawal Rate on a comparable portfolio, we would expect Larry to be able to withdraw about $60,000 a year without worrying too much about depleting the portfolio. That’s pretty close to the $56,919 that he can withdraw using the 72(t) Rule!

So, as you can see, turning your retirement portfolio into an annuity with distributions over your remaining life expectancy mirrors the amount you would expect to receive using the 4% Rule.

I imagine a few lightbulbs are going off right now.

It’s further proof that the 10% penalty is irrelevant! It certainly shouldn’t keep you from shoving as much money as possible into retirement accounts.

Pitfalls and caution

Knowing about the 72(t) Rule is helpful, particularly for those interested in early retirement, but it’s a little more complicated than the other methods I’ve written about and requires that you get a few things right. While this is not a problem for detail-oriented lawyers, I’d work with a professional tax advisor if I implemented this plan.

Here’s a few things you will require your attention:

• Selecting the correct calculation method that makes the most sense for your tax planning (remember, you can only make it once and then you’re locked in).
• Changing your mind after taking SEPP distributions for a few years (you can’t do this).
• Forgetting to take a distribution on time.
• Making sure to file all tax forms correctly to report the exception to the 10% penalty (like Form 5239).

In short, this is a great tool for the early retiree that requires a little planning and professional help but should get you comfortable that retirement money isn’t really as locked away as you might think it is.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He convinces the student loan refinancing companies to give you cashback bonuses for refinancing your student loans and looks forward to you discovering how easy it is to track your net worth with a free tool like Empower.