What is rule 72(t)

Key points

• Rule 72(t) allows access to your retirement funds before age 59½.
• Know the rules of SEPPs to avoid a 10% penalty for early withdrawal.
• There are a few different ways to calculate your SEPP.

Ready to retire? Congratulations! But beware. You may not have access to your retirement accounts until you reach 59½ unless you’re willing to pay a 10% penalty.

Enter Rule 72(t). This section of the IRS code allows funds to be pulled from a retirement account before the age of 59½ without the standard 10% penalty. However, this is typically feasible only for individuals with a substantial balance in their retirement accounts. 

Let’s break down the details of Rule 72(t) in this article to see if it makes sense in your case.

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What is Rule 72(t)?

Rule 72(t) is a section of the IRS code that covers the exceptions and processes that allow you to withdraw your retirement funds early and without penalty. The benefit of retirement accounts is that they shelter your investments from capital gains taxes and have other tax benefits. 

The downside is that you don’t have access to the money earned in your accounts until 59½, and any early withdrawals are subject to a 10% penalty.

However, certain exceptions are in place to avoid that 10% penalty. They vary depending on the retirement account type.

If an exception doesn’t apply to you, then that is when Rule 72(t) comes into play. It allows you to establish a schedule of frequent withdrawals, either a singular annual payment or partial installments, from your retirement account called substantially equal periodic payments, or SEPPs.

Calculations for 72(t) payment amounts

“One common misconception people make when it comes to Rule 72(t) is what ‘equal substantial payments’ actually means,” says Emily Casey Rassam, senior financial planner at Archer Investment Management. “Most people assume $50,000 dispersed over five years means they will withdraw $10,000 annually.”

Unfortunately, the calculations aren’t that simple.

Payments for Rule 72(t) are determined in a few different steps. First, you will need to find out which of the three different IRS life expectancy tables you fit into.

• Uniform lifetime table: for unmarried account holders, married account holders with spouses who aren’t more than 10 years younger, and married account holders whose spouses aren’t the sole beneficiaries of their accounts.
• Single life table: for beneficiaries who are not the spouses of the account holders.
• Joint and last survivor table: for account holders whose spouses are more than 10 years younger and are the sole beneficiaries of their accounts.

After you figure out which life expectancy table you belong to, you will decide how to calculate your SEPP payments to best fit your situation. The three SEPP distribution methods are described below.

Required minimum distribution

The required minimum distribution method nets you the lowest possible withdrawal of the three different options. The calculation is as follows:

Account balance / Life expectancy (determined by IRS table) = SEPP.

The number you arrive at is the amount you must withdraw in the first year. The annual amount will be recalculated using this method each year.

Fixed amortization

The IRS has come up with a not-so-easy-to-understand concept called fixed amortization. Basically, it calculates a fixed payment that is higher than the required minimum distribution but that may not keep up with inflation.

Fixed annuitization

The fixed annuitization method is the most complex of the three payment methods to calculate. It uses an annuity factor to determine your SEPP amount. The annuity factor is calculated based on your life expectancy table as well as an interest rate. Once the annual amount is calculated and paid using this method, that amount must be distributed in the following years.

More about SEPPs

SEPP is an acronym for substantially equal periodic payments. SEPPs are how funds are distributed to you under Rule 72(t). Retirement accounts that are eligible to participate in the rule include the following:

• 401(k).
• 403(b).
• 457(b).
• IRAs.

Now, just because you and your type of retirement account are eligible for Rule 72(t) doesn’t mean the setup of your SEPPs will come easy. There are several rules to follow to avoid the 10% early withdrawal penalty.

1. Minimum withdrawal limit

You must take a minimum of one withdrawal a year for five years or until you reach 59½ years of age, whichever comes later. If you modify your schedule before then, you will be required to pay a penalty on all the funds you have already received.

2. You still pay income taxes

You will still need to pay income taxes on any money that has never been taxed. 

3. Can’t be employer managed

To be eligible for SEPPs, the account you are trying to make early withdrawals from cannot be a retirement account you hold at your current employer.

Example: As you can probably tell, learning IRS jargon and figuring out how to calculate your SEPPs can be difficult. We will use the required minimum distribution method as an example because it is the simplest of the three methods to calculate.

• 50-year-old man.
• 401(k) account = $800,000.
• Life expectancy = 34.2.
• Formula: Account balance / Life expectancy = SEPP.
• $800,000 / 34.2 = $23,292 (first-year payment).

While it is possible to do these calculations at home, it is highly advisable to consult a tax advisor before withdrawing any money from your retirement accounts.

Who is eligible?

Theoretically, anyone is eligible for Rule 72(t). However, it usually makes sense for individuals who have substantial balances in their retirement accounts or are close to age 59½. 

That’s because once you establish your SEPPs, you must receive them for at least five years or until you hit 59½ years of age, whichever comes later. You could incur hefty penalties if you don’t have the funds to cover those years of SEPPs.

To withdraw or not withdraw: making the right decision

Rule 72(t) can be risky if you don’t play your hand correctly.

If you modify your SEPP by taking an annual amount that is different from the annual amount that was originally determined, you will be subject to both the 10% tax on the total distributions in that calendar year and a recapture tax that is equal to the total amount of the 10% tax that would have been imposed for the prior years of the SEPP, plus interest.

That’s why people who successfully use Rule 72(t) tend to be older, meaning they are not committing to as long a lockup period, and tend to have a substantial chunk of money they can use for extra and unforeseen expenses, meaning they will not need to change the fixed payment amount.

Final points

Digesting the ins and outs of retirement accounts and what is and isn’t allowed can be nerve-wracking. Here’s a quick list of key points to remember if you’re still unsure whether Rule 72(t) is right for you. 

• Rule 72(t) allows you to take early withdrawals from retirement accounts without incurring penalties.
• Rule 72(t) is typically best for early retirees or individuals with high balances in their retirement accounts. 
• You must have enough funds in your account to cover at least one payment per year for five years. 
• Not having enough funds to receive five years of payments can leave you subject to hefty penalties. 
• Account withdrawals under Rule 72(t) are still subject to income taxes.

Rule 72(t) can be a useful tool for accessing retirement funds early. But it is important to carefully consider the tax implications and follow the strict distribution requirements to avoid any penalties.

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