What is rule 72(t)?
I’m sure you are already asking what is rule 72(t), and why do I care? I promise I’m going to answer both of these questions for you. Rule 72(t) is a section of the IRS code that allows for penalty free withdrawals from your traditional retirement account prior to age 59 and a half. This means that those who are wanting to retire early or who want more freedom to transition assets out of their tax deferred bucket into their tax free bucket prior to age 59 and a half can do it without having to pay the IRS the normal 10% early withdrawal penalty. As with anything the IRS offers, there’s a number of rules and regulations one should know before they take the plunge and start taking advantage of the loss surrounding the 72(t).
I will be sharing with you the top 10 things you need to know about a 72(t).
You can decide to start taking 72(t) payments from your IRA at any age. That being said, I would not recommend it. Why? Because by law, once you start the 72(t) process, you are required to take annual distributions for a period of five years or until age 59 and a half, whichever is longer. If you don’t, you’re going to have to pay the IRS for all the penalties you were able to avoid using with the 72(t). If you start before your early 50s, the window for potential problems is just too big. Usually we can find other solutions if you’d have that much time available.
The payments must continue until you’re age 59 and a half or for at least five years, whichever period is longer. As I mentioned before, you don’t want to start using the 72(t) too early. You also don’t want to wait because of the five year requirement. It really doesn’t make a whole lot of sense to start a 72(t) at age 58 or even 59. By this age, you have such a little amount of time before you can start taking distributions out of your account without even having to worry about the early withdrawal penalty. A 72(t) is usually not your best option.
The payments must be substantially equal in general. They may not be changed or stopped during the payment term unless you become disabled or die. This is one of the main issues people have with the 72(t). Once you get started, you can’t turn back, and you can’t make changes unless you become disabled or die. Who wants to become disabled or dead just to be able to go back on the original agreement you set up when you started your 72(t) to begin with.
You must take the payment at least annually. You can make payments more frequently if you want, but you can’t stretch them out more than a year. Therefore, you have to be careful with the sequence of return risk as it relates to your 72(t). The last thing you want to do is get to the end of the year and be forced to take a distribution during a down market. My suggestion, if you find that a 72(t) is right for you, is that you make sure you’re working with an advisor who can help you create time segmented portfolios, so you don’t have issues with distributing money during a down market.
The 72(t) rules are only applicable to the IRA or IRAs from which you calculate your initial payment. Now, what does this mean? This means that whatever is in your IRA account when you start will all be subject to the 72(t) rules. Since a large portion of retirees who want to use the 72(t) only want to apply to a portion of their IRA assets, the best recommendation is for them to split out their account prior to starting a 72(t).
Let me give you an example to help better explain what I’m talking about. Let’s assume you have a million dollar traditional IRA, but you only want to transition $500,000 out and then leave the remaining $500,000 in the traditional IRA account, so you have the right amount in your tax deferred bucket. In order to do this, you will want to create two separate IRA accounts with each account holding $500,000 of asset. Then you only pick one of the accounts to use for the 72(t) purpose.
The IRS has approved three methods of calculating 72(t) payments. Those methods are the required minimum distribution method, the amortization method, and the annuity factor method. Most people prefer the RMD method because they’ll produce smaller payments than the other two methods to start out.
While other methods of calculating the payments besides these three are not prohibited, it would be extremely risky to use some other method that is not officially approved by the IRS. The calculation part of the 72(t) process is way too complex to cover in one sitting. If you’re serious about a 72(t), I’d recommend you consult with one of our certified advisors to help you calculate the 72(t) payment.
You can switch to the RMD method from either the annuity or the amortization factor method. If you decide to do this, though, you need to know that this is a one time irrevocable switch. Once you make this change, you’re going to have to use the RMD method for calculating your payment for the remainder of your payout schedule.
If you do not stick to your 72(t) payment plan, or if you modify the payments, they will no longer qualify for the exemption from the 10% IRS penalty. I mentioned this earlier, but if you get sideways with your 72(t), you’re going to have to pay the IRS 100% of the penalties you would have paid had you not even gone with the 72(t) in the first place. This applies even if you end up falling out of compliance after you’ve reached age 59 and a half. Any pre age 59 and a half distributions will be subject to the penalty.
Any extra contribution or withdrawal is considered a modification of the payment schedule. Any change in the account balance other than by regular gains and losses or regular 72(t) distributions will be considered a modification and a 10% penalty will be triggered. You have to be extremely careful with your 72(t) IRA account because even if you accidentally put money into the account, you can be subject to blowing up the whole process. Who wants to spend four or five years systematically doing what you’re supposed to and then have it all unraveled in the end?
You may not roll over or convert your 72(t) payment. This is a misconception many people have when I teach this principle in my webinars. They think the whole purpose of a 72(t) is so you can convert the assets into a Roth IRA. As a result, many of them question why you wouldn’t just do a regular rollover. The primary purpose of doing a 72(t) is to buy you freedom on what you can do with the money you pull out.
There are four main things people use 72(t) money for. The first is for their lifestyle. Second is to be able to have money to pay the taxes. If you have a large IRA that you need to convert, you can separate the account and then use the 72(t) account to pay the taxes without having the penalty.
Third is to buy a life insurance retirement plan. These have a cost, and that is you have to pay taxes on the money going into the policy. Therefore, many people use the 72(t) as a way to fund these plans pre 59 and a half and not have to worry about the early withdrawal penalty imposed by the government.
Fourth is to fund current Roth contributions. The only time this is generally done as if the individual doesn’t have enough other assets to be able to pay for the taxes. They can use the 72(t), which will then allow them to use some of the money to pay for the taxes that are caused because the money coming out of the tax deferred account, and then use the remaining money for a new contribution into the tax free account.
I do realize a 72(t) is not for everyone, and it’s generally only used by a small portion of the population. However, I want you to understand it because I believe it’s another tool in the shed you can use to help get some of you to a tax-free and risk free retirement.