Accessing Retirement Funds Early Through Rule 72(t)
Tax-Advantaged Retirement Accounts
To encourage retirement savings, the Internal Revenue Code (IRC) provides individuals and families that have earned income access to tax-advantaged retirement accounts. These can come in the form of Individual Retirement Accounts (IRAs), or company-sponsored plans such as 401(k)s.
As an incentive, contributions to traditional/pre-tax accounts receive a tax deduction on the front-end and tax-deferred growth until funds are disbursed. However, to disincentivize funds being distributed out early (before age 59 1/2) the IRC slaps a 10% tax penalty in addition to regular income taxes owed on distributions taken before age 59 1/2 (in most cases). This is the double-edged sword the IRC uses to promote habitual savings and patience with deferred gratification.
The IRC does allow for penalty-free withdrawals in certain situations such as:
Unreimbursed deductible medical expenses (beyond 10% of adjusted gross income),
Distributions made by individuals who are totally and permanently disabled,
First-time home buyers (limited to an IRA and maximum amount),
Paying for health insurance premiums if you are unemployed (certain conditions must be met), and a few more.
Our team encourages investors to delay accessing their retirement savings, however, we know that life can come with huge curveballs, and plans change. And because unforeseen scenarios happen, funds may be needed from places you didn’t intend on using for many years. Here’s how Rule 72(t) can be utilized.
Rule 72(t)
Rule 72(t) was designed to provide additional access to penalty-free funds out of retirement accounts. Rule 72(t) pushes aside the nuances associated with other allowances for penalty-free distributions, but as you can imagine, it comes with its own set of distinct and strict rules.
If not followed accordingly, it can create significant problems for the taxpayer.
Length of Withdrawals & Penalty for Not Following
When accessing retirement assets early using Rule 72(t), a series of Substantially Equal Periodic Payments (SEPPs) are created. The length of this series is determined by the age of the taxpayer at the time these payments begin.
According to IRC Section 72(t)(4)(A), a taxpayer who begins taking distributions must take them for the greater period of 5 years or until the age of 59 1/2 is reached for the taxpayer.
Example 1: Jim is 58 and begins to take SEPPs from his rollover IRA. Because he only has 1.5 years until he reaches 59 1/2, he must take five payments over the next 5 years (through the age of 63).
Example 2: John is 42 and begins taking SEPPs from his rollover IRA. Because he has 17.5 years until he reaches 59 1/2, he must take payments through the age of 59 1/2.
This is an important function of the rule because once the SEPP schedule has been established, it must be followed through accordingly, otherwise, all pre-tax distributions taken before age 59 1/2 will be retroactively hit with the 10% penalty (and interest on the penalties as if they were paid at the time of the distribution!).
Missing just one payment (or changing the schedule) can create a substantial tax bill for the taxpayer which cannot be remedied.
Calculating the Payment
In 1989, the IRS set forth three methods by which taxpayers could calculate their SEPPs.
RMD methodology
Annuitization methodology
Amortization methodology
Each of the three methods uses either an applicable life expectancy or mortality table to calculate the set of annual payments.
The RMD Methodology
Similar to “normal” required minimum distributions (e.g. those that start at 72), the RMD method for SEPPs divides the taxpayer’s account balance each year by the appropriate life expectancy factor, creating distributions that vary year over year. Although the life expectancy factor increases over time, this methodology typically results in lower annual distributions allowed from the taxpayer’s accounts. For those trying to get more out of their retirement accounts, the other methods create higher distribution levels.
The Annuitization Methodology
The annuitization method is calculated by dividing the initial account balance by an annuity factor, creating a consistent distribution level throughout the life of the SEPP. The annuity factor itself is derived using applicable mortality rates and a “reasonable interest rate.”
Prior to this year, a “reasonable interest rate” was determined as no greater than 120% of the applicable mid-term Federal rate. In January of 2022, the IRS released Notice 2022-6, which provides friendlier interest rate levels for calculation purposes. Now taxpayers may use the greater of 5% or 120% of the applicable mid-term Federal rate.
The Amortization Methodology
Like the annuitization method, the amortization method also uses the new “reasonable interest rate”, paired with an applicable life expectancy factor to determine annual payments.
With the new floor on “reasonable interest rates” the amortization method allows for the highest level of distributions across assets, with the annuitization methodology close behind it. The RMD method is now significantly lower in comparison to the two fixed-level distribution methods.
It’s important to note that the annuitization and amortization methods allow a one-time switch to the RMD methodology, if the taxpayer desires, however, those who initially choose the RMD method cannot switch to the other methods. Simply put, you can transition to the RMD method, but you can’t transition away from it.
Applying Rule 72(t)
Rule 72(t) does not require an all-or-nothing approach with retirement assets. Because of this, taxpayers can split assets accordingly to produce their desired level of annual payments.
This initial funding amount can be backed into by knowing what a taxpayer’s cash flow needs are and setting aside the applicable amount to meet that annual level. Taking this approach can limit the realized taxable events while providing a consistent stream of cash flow to the taxpayer. It also provides a smaller balance to switch to using the RMD method if the taxpayer no longer has a need for the cash flows and wants to minimize taxable income in the future.
To do this effectively, the assets should be split between two separate accounts, so it is made clear which assets are being used for 72(t) purposes. Splitting your assets also leaves you with more flexibility should you need to take additional distributions in the future. Although you may be liable for the 10% penalty on a non-72(t) distribution, it is much better than paying the penalty on all prior distributions because you pierced the veil of the SEPP schedule.
Navigating Your Journey
Although most people will not need to access their retirement assets until past the age of 59 1/2, it is helpful to be aware of options should your life or goals change. For those seeking to retire “early”, Rule 72(t) can be a helpful way to access funds for living needs, without having to build large levels of taxable dollars for that interim period.
In addition, it may be a more tax-efficient approach to take the taxable income earlier if that means the taxpayer can spread out their tax bill at lower tax brackets over a longer period, rather than taking higher distribution amounts later in life at potentially higher tax brackets.
Establishing a SEPP schedule should not be done lightly or without significant thought and analysis behind it. Starting a schedule will set forced taxable events in motion, and if goals or life change again, it may not be desired anymore. This could prove costly with missed opportunities for tax-deferred growth in the future and the potential for withdrawals at higher marginal tax rates.
Options like Rule 72(t) remind us how important it is to consider both sides of the retirement equation simultaneously - both the accumulation phase and decumulation phase - to ensure you are being efficient and strategic with your assets.
We Can Help
If you find yourself needing some assistance navigating or planning toward retirement, our team would be happy to help. Please contact any of our team members at Kings Path to see how we might be able to serve you through a personal and strategic approach.
