![What is the 72t rule](https://financesandtaxes.com/wp-content/uploads/2022/03/72TRule.jpg)
What is 72t
72t Rule is an IRS rule that allows retirement savers access to retirement accounts before the golden age of 59½ without incurring the 10 percent early access penalty. It’s often referred to as “72t” due to its location in the Internal Revenue code.
Individual Retirement Accounts are long-term savings vehicles to secure life in retirement. To secure this, and discourage premature access, IRS imposes a penalty of 10% on any withdrawals before age 59½, taxes also accrue on the payout of tax-deferred accounts.
However, IRS agrees that in certain selected situations, account holders may need to tap their retirement funds prematurely. IRS will exempt the 10% tax penalty under the following situations:
- Death or Disability
- Certain medical expenses
- Qualified educational expenses
- First-time home buyer purchase
- Qualified birth or adoption
- Payment of IRA taxes
- 72t distributions known as Series of Substantially Equal Periodic Payments calculated based on life or life expectancy(SEPPs)
SEPPs are calculated based on life or life expectancy (SEPPs). Setting up the schedule of SEPPs is not simple, and certain rules have to be followed:
Schedule annual payments at a minimum.
Several installments can be scheduled in a year, but you must take at least one installment every year for five years or until you turn 59 ½(whichever is longer-Thereafter, you are free to take payments from the IRA as permitted by law).
Do not miss even a single payment, else you will owe IRS 10% withdrawal penalties retroactively on all funds that you have already accessed under the SEPP plan.
The only exception applies to death or you being permanently disabled.
Below are examples;
- If you start taking SEPPs at age 50, you can continue until age 59-½ (9½ years).
- Taking SEPPs at age 55, this must continue until age 60 (minimum is 5 years).
- If you start SEPPs at age 57 and become disabled at age 58, you can stop payment immediately due to the disability exception.
Paying off taxes on tax-deferred savings.
You are required to pay accrued taxes on contributions and earnings in your tax-deferred accounts, including investment gains withdrawn from Roth accounts (Contributions are from after-tax dollars hence not taxable).
Watch out as this could push you into higher tax brackets.
The account is technically frozen
You are not allowed to fund or withdraw funds from your IRA with a 72t payment plan in progress. This account is essentially frozen until all payments are complete.
You won’t access savings from an account managed by your current employer.
Retirement accounts tied to your current employer are not eligible for SEPPs.
SEPPs are advisable if:
- You have access to a well-structured retirement plan with diverse assets.
- Time commitment associated with SEPPs payments is not an issue.
- There are plans to retire early and may need to access your retirement account before age 59½.
Calculating SEPPs
The calculation of SEPPs is based on life or life expectancy. IRS bases life expectancy through 1 of 3 ways bellows;
Minimum Distribution Method(RMD)
This is determined as follows;
- The age of the pension saver is located on the RMD IRS table. This determines which divisor you will use for your age.
- Divide previous years’ (December 31st) account balance by the divisor in step 1. This will be your payment for the year.
You will notice that the annual early withdrawal payments are more likely to vary year by year. But overall, it should remain consistent. It’s the best method if wide fluctuations are expected in your account values.
Note that this payment scheme results in the lowest possible amounts to be accessed. Its common practice to recalculate the amounts allowed to withdraw yearly as IRS updates the RMD table each passing year.
Fixed Amortization Method
Follow below to work out the payments;
- Take your most recent account balance and determine a reasonable interest rate to prepare an annual withdrawal schedule. IRS limits the use of rates over 120% of the mid-term Applicable Federal Rate. This approach ensures that you do not prematurely deplete your retirement savings.
- The next step is creating a schedule out of the IRS life expectancy table. Use either the Single life, Joint life (oldest named beneficiary), or Uniform life table.
This method amortizes your IRA’s balance over your single or joint life expectancy. It will determine the most reasonable fixed amount you can access on a yearly basis.
This method allows the largest amounts from your IRA.
Annuitization Method
You can work out your payments as follows;
- Determine Taxpayer’s account balance
- Divide step 1 by an annuity factor equal to the present value of an annuity of $1 per month beginning at the taxpayer’s age in the first year of payment and continues for the life of the taxpayer. Use the non-sex-based mortality table published by IRS.
Take note that this will be based on your life expectancy, not the age of your beneficiary.
This method will provide equivalent or nearly-equivalent amounts in line with 72t rules. It provides fixed annual amounts based on the IRS annuity factor method.
Payments typically vary between the highest and lowest possible amounts.
Does rule of 72t apply to IRA
IRS allows account owners to take 72t payments for any reason and at any time without the additional 10% penalty.
This may begin;
- At any age under 59½ and;
- A set SEPPs schedule paid out annually in accordance with IRS rules and;
- Should be based on your life expectancy or joint life expectancy (using the oldest named beneficiary).
72t 5 year rule
IRS mandates annual payments. Furthermore, they must continue for the latest of;
- Minimum of 5 years or if later;
- Until the time until the taxpayer turns age 59 ½ (whichever comes last).
The two conditions above will create years of locked-in taxable income.
IRS doesn’t consider you done once you take the last payment. You should be careful in making transactions before the end of the fifth year else IRS might deem it as a modification.
Market downturns can exhaust your IRA balance five years from the date of the first installment or until age 59½, whichever is longer. Should this happen, you are not liable for the 10% early access penalty.
Can I take a distribution from my 401k
Qualified plans are exempt from penalties if early access is part of the SEPPs series.
Qualified retirement plans eligible for Rule 72(t) include;
However, to qualify for this exception;
- You have quit from current employment to qualify for this exception, but
- Rule of 55 or older requirement is not applicable to you.
IRS bases this payment on your life expectancy.
Can you change your 72t distribution
Yes, the only change allowed is;
- The method used to calculate SEPPs e.g. from the amortization or annuitization method to the RMD method.
You cannot change from;
- Using the RMD method to either the amortization method or annuitization method, or
- The amortization method to the annuitization method, or vice versa
Once you make the above changes, you cannot make any other changes.
IRS will charge the 10% penalty (inclusive of interest on the penalty) retroactively to all payments made before attaining the age 59½.
Changes that trigger the 10% penalty tax include;
- Funding the IRA account apart from investment gains or losses.
- Transfer of any non-taxable portion of the IRA balance to another IRA except certain transfers in divorce settlements.
- Tax avoidance by rolling over the 72t payments so that they are not taxable.
- Not taking 72t payments as per the 72t method and schedule applied
- Taking additional payments beyond the SEPPs for the year.
Can you have multiple 72t accounts
IRS doesn’t allow multiple 72t accounts. So, always re-arrange your IRA account(s) before setting the plan in motion.
The taxman will focus on the account that pays the SEPPs. It’s advisable to leave the least amount that will yield the desired payment.
Bottom line.
Consider 72t payments only as a last resort since they are extremely restrictive. Please note these rules;
- Should you stop or change your 72t payments, the IRS will retroactively charge the 10 percent penalty on any funds accessed before age 59½.
- IRS deems 72t payment as taxable income. This can easily push you to a higher tax bracket.
- You ran a chance of depleting retirement accounts and risking poverty in old age.
- IRS deems this account frozen. Plan to increase or decrease the IRA account from other IRA account(s) before you roll the SEPP payments.
Leave a Reply
You must be logged in to post a comment.