How to Use New 72(t) Rules to Your Advantage
If you want or need to retire early, you might be considering early withdrawals from your retirement accounts. Normally, rules prevent you from taking early distributions without getting penalized. However, you might have heard that 72(t) rules enable you to bypass those penalties.
The rules are complicated, but recent changes could make 72(t) payments worth your while. Substantially equal periodic payments (or SEPPs) are a complex subject with strict rules and costly penalties for mistakes. We recommend you work with a financial advisor to determine if this strategy is the best option and help ensure you get the details right.
That said, this article provides a brief overview to help you determine whether 72(t) early distributions would be helpful.
What Is the 72(t) Payment Strategy?
The 72(t) payment strategy allows you to take early withdrawals from your IRA or 401(k). Usually, if you take early distributions, you face a 10% penalty on top of income taxes.
The Internal Revenue Code section that outlines emergency exceptions (such as death or disability) is Section 72(t). This section also outlines how using SEPPs can enable you to bypass the 10% penalty, although you still owe any required taxes.
So what are SEPPs? Substantially equal periodic payments are a mouthful of a way to say you set up penalty-free withdrawals from your retirement account.
But be aware that once you set these payments up, you must continue them for at least five years or until you reach age 59 ½, whichever comes later (not first!). So if you begin SEPPs at age 50, you cannot stop them before age 59 ½, even if you no longer need the money five years into taking them.
How Do 72(t) Payments Work?
You and your financial advisor will set up SEPP withdrawals based on an IRS-required formula using one of three methods:
Required minimum distributions. You’ll calculate your RMD by dividing your account balance by a life expectancy factor from the IRS.
Fixed annuitization. Your withdrawal amount will be based on a specified interest rate and life expectancy table.
Fixed amortization. You’ll use an annuity factor based on your age to determine your payment amount.
Recently, the IRS released Notice 2022-6 (you can read the PDF here), which could increase your payment amounts. The change is due to the new minimum interest rate of 5% for calculating payments.
According to a Kitces.com article covering the recent changes to early distribution payments:
The new “floor” interest rate represents a “substantial increase over the previous maximum of 120% of the applicable federal midterm rate. Thus, for a 50-year-old with a $1 million retirement portfolio, this means the maximum annual 72(t) payment increases from about $37,000 to over $63,000!”
The article adds that the change is significant enough that you may need to consider ways to reduce your 72(t) payment. For example, you might split your retirement plan into two accounts, with one used only for SEPPs.
You can also do a one-time change from the annuitization or amortization method to the RMD calculation, which generally results in lower payments.
Why You Should Partner with a Financial Advisor on This Strategy
Like all things tax-related, the 72(t) strategy is complicated, and mistakes get penalized. The penalty (plus interest) won’t just apply at the time of your error. It will be retroactive to all distributions that you have taken.
It’s also easy to overestimate how long a retirement account can sustain you. This SEPP article published on MSN provides a dire example of one 57-year-old who began periodic payments with $1.3 million in her retirement plan. The withdrawals and market volatility reduced her account balance to $300,000.
“We had to tell her that she was on her way to running out of money around age 60 and would have to think about going back to work. … That was certainly not the outcome she had desired when she retired, but she thought she was fine because the numbers seemed to work.”
A financial advisor with expertise in retirement planning and a fiduciary obligation to your best interests can help you determine the right calculation based on your financial situation and goals. They could even alert you to other strategies that you might not have known about on your own.
We offer a complimentary 15-minute call to discuss your financial situation and concerns and share how we may be able to help.
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