Generally, distributions from your IRA before age 59 ½ are subject to a 10% penalty plus ordinary income tax. Ouch! The good news is there are exceptions to those rules like anything else in finance. The more commonly known exceptions include funds used for:
- Qualified higher-education expenses
- Medical expenses
- First time home purchase
One exception that isn’t as well-known is equal periodic payments. It is more commonly known as 72(t) because of its reference in the IRS code. 72(t) is an IRS rule that lets you withdraw money from your retirement accounts before age 59.5 without incurring the 10% penalty or meeting one of the other exceptions. This strategy may be a valuable tool for those considering early retirement.
Here’s the catch
When you hear something that sounds too good to be true, it’s either not true, or it comes with an extensive list of ifs and, or buts. Here is the actual rule from the IRS website. Anyone can use the 72(t) code to tap into their retirement funds before 59.5 without the 10% penalty. The catch is you must follow extremely specific rules. You must take substantially equal periodic payments based on an IRS formula each year for five years or until your reach age 59.5, whichever is longer.
The five years or until you reach 59.5 can get a little tricky. For example, if you start your 72t distributions at 52, you will have to continue distributions until age 59.5 (a total of 7.5 years). If you start at 55, you will have to continue until age 60 (a minimum of 5 years).
IRS formulas and updates
Unfortunately, you are not at liberty to arbitrarily pick your distribution amount. The IRS defines substantially equally payments and provides three approved formulas for calculating them. All of which are designed to pay out the entire account in nearly equal payments throughout your expected lifetime.
- Required minimum distribution method: Divide the money available in your IRA by your remaining years of life expectancy. You don’t get to pick your actual life expectancy either. In its infinite wisdom, the government has a life expectancy table for you. This method provides the smallest payment of the three options and is recalculated each year based on your age and the remaining portfolio balance. Your amount can go up or down depending on how your investments perform.
- Fixed amortization method: This is a fixed annual payment based on the expected draw-down amortization of your life expectancy. This method typically provides the highest payments.
- Fixed annuitization method: Payments are based on an annuity factor, again established by the IRS. This method is the most complex, and payments typically fall between the other two options.
In January of this year, the IRS issued new guidance concerning the interest rate factor in calculating and distributing those payments, plus updated the life expectancy table. The recent change to the life expectancy table will even impact people who have previously elected the required minimum distribution method and have not yet completed the time requirement. We suggest working with your accountant or advisor on selecting a method and calculating the proper distribution amounts.
Knowing when to apply 72(t)
While taking penalty-free IRA distributions before 59 ½ can be appealing, it is not a strategy that makes sense for everyone or every situation. Starting distributions from retirement accounts early goes against the basic principles of allowing your tax-deferred accounts to grow tax-deferred for as long as possible, allowing for a greater probability of running out of money in your later years. Even so, 72(t) can be part of a well-structured thought-out plan for those who have substantial assets across different accounts and have exhausted other cash flow options.
The rules and calculations can be complex, and as just mentioned, the rules have recently been modified, making them even tricker. If you do not follow your 72(t)-payment plan or inaccurately change the payment, you will no longer qualify for the exemption. To add insult to injury, the 10% penalty will be reinstated retroactively to all the distributions you have taken before age 59 1/2. Don’t overlook your tax liability. Even though you avoid the 10% penalty by following the rules, the withdrawals still count as taxable income, which could push you into a higher tax bracket.
As you can see, there are many things to think about when considering this route. This article is just the tip of the iceberg regarding 72(t). Anyone considering this strategy should have a long-term plan and be comfortable with the time commitment. Retiring early and committing to these payments is a big decision, and the penalties for mistakes can be substantial. On the other hand, successfully creating a plan to retire early is impressive. The 72(t) code could prove to be a valuable strategy in your plan. Before executing this strategy, getting expert advice from a financial and tax professional is a wise move. Helping people achieve their retirement goals is our passion. Give us a call if you need assistance.
This material is provided as a courtesy and for educational purposes only. Investing involves risk including loss of principal. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. This article contains links to articles or other information that may be contained on a third-party website. River City Wealth Management is not responsible for and does not control, adopt, or endorse any content contained on any third-party website. The information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. Past performance is not indicative of future results.