Woman calculating 72(t) distribution

What is a 72(t) Distribution?

If you withdraw money from your tax-deferred IRA or 401k accounts before you turn 59.5 you will owe a 10% penalty in addition to income tax.  A 72(t) distribution is a way of accessing the money in your retirement account before you turn 59.5 without incurring the penalty.

No doubt, you are aware that withdrawing from your retirement accounts early is an excellent way to  ruin your retirement. For many, its a guarantee that their money will not last for as long as they need it to.

For some, withdrawing the money early is necessary. Maybe you lost your job close to the time you planned to retire anyway. It may not be worth it to you to look for another job just to retire shortly. The reality is, it may be difficult to find a job comparable to the one you had.

For others, early retirement may be possible with early withdrawals. For instance, consider the military reservist. Typically, retired pay for military reservists starts at 60. Social Security benefits and military retirement may be enough to support your lifestyle in retirement. You may decide to retire before these pension payments start by withdrawing from your IRA or 401k.

Regardless, everyone’s situation is different. If early distributions make sense for you, Internal Revenue Code Section 72(t) provides the way.

How Does a Rule 72(t) Distribution Work?

Simply stated, IRC Section 72(t) allows you to avoid the 10% early withdrawal penalty for withdrawals prior to 59&1/12.

Rule 72(t) provides several ways to avoid the early withdrawal penalty. Death, disability, turning 59&1/2, and leaving your employer after turning 55 are some of them.

When most people think of 72(t) distributions they are thinking specifically of Section 72(t)(2)(A)(iv). In order to qualify for the early withdrawal penalty with this exception, the payments must be (paraphrased)…

Substantially equal periodic payments (SEPP) expected to occur for the remaining life of the individual, or the joint-life of the retiree and beneficiary.

Basically, this means that as long as you are taking equal payments over your life expectancy then you can bypass the 10% penalty. Your payment frequency cannot be less than annually.

Of course, the devil is in the details…

How Do I Calculate Substantially Equal Periodic Payments for Rule 72(t)?

There are three specific ways that you can calculate your distributions. As long as you use one of these three methods then they will be deemed to be substantially equal.

1. Required Minimum Distribution Method

For this method, you calculate your payments just as you would for required minimum distributions. You divide your account balance by your life (or joint-life) expectancy  each year. Since both your account balance and life expectancy will change each year, the dollar amount of your withdrawal will change each year. That is fine. As long as you don’t start using a different method then you will be in compliance with the “substantially equal” notion of the rule.

2. Amortization Method

Amortizing your account means that you take withdrawals that would be expected to empty your account. This is the same way that loan payments are determined for a mortgage, just in reverse. You need the account balance, life expectancy, and an interest rate in order to amortize your account balance.

Again, your life expectancy is determined using the IRS tables for either your single life or the joint life of you and a beneficiary.

The interest rate is any rate that does not exceed 120% of the federal midterm rate for either of the two months that precede the month you take your first distribution. That’s a mouthful, but you can simply get the interest rate here. The IRS updates this each month with the new rate for that month. Choose the rate under the annual column, in the mid-term section, next to 120%.

Once you calculate the withdrawal for the first year it does not change.

3. Annuity Method

The annuity method is similar to the amortization method in that once you calculate the payment for the first year it does not change. For this method, you first calculate the present value of an annuity for your life expectancy. In this context, an annuity means a fixed payment amount for each year of your remaining life expectancy.

The present value that you calculate is called the annuity factor. Divide your account balance by the annuity factor to get your withdrawal amount. The interest rate and life expectancy that you use is the same as for the amortization method.

Other Considerations for 72(t) Distributions

There are a few other items worth mentioning regarding substantially equal periodic payments under rule 72(t).

  1. Once you begin your distributions, you cannot stop for at least five years. You have to take distributions for a minimum of five years even if you turn 59&1/2. If you are 59&1/2 you can stop distributions one you have passed five years.
  2. If you start withdrawals with either the amortization or annuity method, you are allowed to switch to the required minimum distribution method. You cannot switch any other way. For instance, you cannot switch from the annuity method to the amortization method or from the required minimum distribution to one of the others.
  3. If you are 55 and retiring from an employer with a qualified plan you can take distributions from the plan and avoid both the early withdrawal penalty and the 72(t) restrictions. In this case, don’t roll your money into an IRA. Take your distributions directly from the plan.

Planning with 72(t) Distributions

72(t) distributions  make the most sense for people who are able to retire earlier than the normal 59&1/2 age restriction. If you are considering an early retirement and thinking about using 72(t) distributions then make sure you account for each detail. 72(t) distributions are notoriously complicated and can trigger the penalties that you wanted to circumvent if not done correctly.

As with any distribution strategy, make sure to account for the possibility of a long life. Early withdrawals make this assessment even more important. You will be withdrawing more due to the fact that you will take more withdrawals, and your money will not have as many years to compound.

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