If you’ve ever wanted to get early access to your retirement savings before age 59-1/2 without having to pay the additional 10% penalty, then you might be delighted to know that there is a little known exception to this process known as the 72t rule.
According to the exceptions listed in Section 72(t)(2), the owner of the retirement fund can elect to take distributions using something called a series of substantially equal periodic payments (or SEPP for short). What this means is that you and the IRS would agree to take out pre-calculated amounts each year for the next 5 years or until you turn age 59-1/2 (whichever is later). Each of those distributions would then be free of the 10% penalty!
Here’s how this would work:
The 72t Rules:
SEPP’s get calculated by using one of three methods:
- The Required Minimum Distribution Method is where you take your current balance and divide it by your single life expectancy or joint life expectancy. Over time your amounts will vary slightly from one year to the next. But this method also produces the least amount of money withdrawn each year.
- The Amortization Method figures out your distribution by amortizing your account balance over your single life expectancy (similar to how a bank calculates a 30 year fixed mortgage).
- The Annuitization Method uses an annuity factor to calculate your SEPP.
Each of these methods is based on a mortality table that takes your life expectancy into consideration.
If you elect to go with either the second or third method, they have you specify an interest rate that is not more than 120% of the federal mid-term rate. Depending on the variables that go into the calculation, the second or third method may be more than the other.
If you ever feel like you have made the wrong decision using one calculation method versus another, the IRS does allow a “one-time” conversion where you can go from one method to another.
- Running out of money too soon. The biggest problem with using a 72t to get early access to your retirement savings is that you might pre-maturely deplete the account. Even though each of the three distribution methods is designed to be somewhat conservative, there is still some risk that you won’t have as much money as you would like later on due to the early withdrawals.
- Incorrect distributions. If you calculate the wrong amount, take too much / too little of a distribution, or report it incorrectly to the IRS, you’ll find yourself right back in front of that nasty 10% penalty again. The aide of an accountant or tax professional would be highly advised in this process.
How to Initiate a 72t Distribution:
If you plan to take the distributions from your employer-sponsored plan like a 401k, then you must separate with that employer first. From there you can then work with your 401k administrator to begin receiving the 72t distributions.
Sometimes even after separation an employer will not allow you to make withdraws. If that happens, then the next thing you’d want to do is rollover the balance to a Traditional IRA that will be under your control.
Once you’ve got access to your money, the next step would be to decide which of the three withdrawal methods you’d like to exercise and how much of your money you’d like to use. You do not necessarily need to use the full balance of your 401k or IRA. Again – make sure you’re not over-withdrawing from your account such that it will cause you problems later on during retirement.
From there remember to take exactly the amount you have calculated each year for a distribution. Work with your account provider and tax professional to ensure that the correct amount gets reported each year to the IRS per the 72t rules.
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