Retirement accounts are a popular way for Americans to save for their latter years. Investments are able to grow, and taxes are deferred, until needed. But what happens if life gets in the way and you need to dip into your nest egg sooner than expected? In most cases, early withdrawals from retirement accounts are accompanied by a 10% tax penalty. There are, however, a few exceptions to this rule, one of which is known as Rule 72(t).
What is Rule 72(t)
Rule 72(t) refers to a section of the IRS code outlining instances where early withdrawals from qualified retirement accounts such as IRAs, 401(k)s, and 403(b)s are not subject to a 10% penalty. These include permanent disability, some medical expenses, inheritance, a first-time home purchase, and college tuition payments. In lieu of these, Rule 72(t) allows you to establish a schedule of early withdrawals from a retirement account known as substantially equal periodic payments, or SEPPs.
In order for these payments to qualify, the owner of the account must take at least five SEPPs over the course of five years. They can be scheduled multiple times per year, but one must be taken at least once per year for five years, or until the account owner turns 59 ½ (whichever comes later). The amount of each installment is calculated by one of three IRS approved methods: Amortization, Minimum Distribution, or Annuitization. Each method utilizes IRS life expectancy tables and the balance of the retirement account to calculate installment amounts.
Amortization calculates payment amounts using life expectancy and the federal mid-term rate, which is a special rate set by the IRS for various tax purposes. The amount is fixed annually, meaning it cannot be changed. This method produces the largest withdrawal amounts, but due to its fixed nature is also the most vulnerable to changes. If the value of your retirement account tumbles or your cashflow needs change, the distribution amount cannot be altered.
Minimum Distribution uses the IRS life expectancy table to divide the balance of a retirement account. It works similarly to required minimum distributions during retirement. Unlike the amortization method, the withdrawal amounts are likely to vary from year to year, though probably not by much. This method produces the smallest withdrawal amounts.
Annuitization uses an annuity factor provided by the IRS as well as the federal mid-term rate and retirement account balance to determine payments in accordance with SEPP rules. This method produces fixed withdrawal amounts, typically falling somewhere between those of the amortization and minimum distribution methods.
Rule 72(t) withdrawals are still subject to income tax. You cannot take SEPPs from an account managed by an employer you’re still working for. Any withdrawals that don’t meet all requirements of Rule 72(t) will be subject to a 10% withdrawal penalty. Because of this, SEPPs should be taken with great care and planning, and should be considered a last resort when other financial options have been exhausted. There’s a reason the IRS has exceptions for things like illness and disability. Early withdrawals from retirement accounts cause you to lose out on potential compounding gains which can have a significant effect on your future financial stability.
The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.
Certain of our representatives are Certified Public Accountants with the accounting firm Ben H. Crowe, C.P.A., LLC which is affiliated with Marietta Wealth Management. To the extent that these representatives provide accounting services, which may include tax advice, to any clients, including our advisory clients, all such services shall be performed by those representatives, in their individual professional capacities, independent of our advisory firm, for which services we shall not receive any portion of the fees charged by the representative, referral or otherwise. It is expected that these representatives, solely incidental to their practices as accountants, recommend our advisory services to certain of their clients. No client of Marietta Wealth Management is under any obligation to use the accounting services of these representatives. Our Chief Compliance Officer remains available to address any questions that a client or prospective client may have regarding this potential conflict of interest.