What is Rule 72(t)?
With people living longer and retiring earlier, many face a challenge if most, or even all, of their assets are in traditional retirement accounts. Why? Because they can't take the money out if they do want to retire early! That's precisely where Rule 72(t) can come into play for early retirement.
Generally speaking, retirement account distributions come with taxes and a hefty 10% penalty if taken out before age 59.5. However, there are still strategies to explore that may allow you to work around the penalties for those who haven't planned for this situation. One of those solutions is IRS Rule 72(t), which allows for "equally substantial periodic payments" to be taken out a minimum of five years or until age 59.5, whichever is longer, without penalty. In all circumstances, after the 72(t) distribution period has been satisfied, you can take distributions freely as needed. A few formulas can be used to determine your distribution amount, but be aware of the nuances of each, as well as pitfalls you may run into when implementing Rule 72(t).
There are generally three methods you can follow to satisfy Rule 72(t) distribution requirements:
1. The Required Minimum Distribution (RMD) Method
The RMD method will typically produce the smallest annual distribution amounts compared to the other two. With the RMD calculation, the distribution amount is determined by your account balance and life expectancy table. The distribution is recalculated each year, similar to RMDs later in life, based on the account balance on 12/31 of the prior calendar year. This method will mitigate market volatility concerns because each year's distribution reflects the previous year's account balance (see below). Ex: A 50-year-old with $1M in retirement accounts using a single life expectancy table would take the $1,000,000.00/36.2 (the life expectancy factor for 2021) = $27,624.31 that must be taken out the first year.
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2. Annuitization Method
In the annuitization method, the account balance is applied to an annuity factor based on mortality tables and an interest rate no more than 120% of the federal mid-term rate. The calculation provides an annual payment in which the same dollar amount must be taken out each year, regardless of market fluctuations. The annuitization method can generally offer a higher allowable distribution amount in a year as compared to the RMD method. For example, a 50-year-old with $1M in retirement accounts using a 2.5% interest rate may be eligible to take out near $42,074 using the annuitization method.
3. Amortization Method
The amortization method takes the account balance amortized over a specific number of years equal to life expectancy and an interest rate no more than 120% of the federal mid-term rate. Once the annual distribution amount is calculated, the same dollar amount must be distributed in the years following regardless of market fluctuations. In year one, the amortization method can generally provide a higher allowable distribution method than the RMD method. For example, A 50-year-old with $1M in retirement accounts using a 2.5% interest rate and a single life expectancy may be eligible to take out near $42,306 using the annuitization method.
Note: The interest rate used to calculate the benefits for both the annuitization and amortization methods were once capped at a very low rate. In 2022, a significant change now applies that raised the minimum interest rate that can be applied up to 5%. This change allows for much larger distributions in certain situations. It also enables the tax-payer to pick the greater of 5% or 120% of the federal mid-term rate. For example, A 50-year-old with $1M in retirement accounts using a 5% interest rate may be eligible to take out well over $50,000 per year with the new interest rate allowed.
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One of many things to be cautious of when it comes to Rule 72(t) is to be aware that these distributions must be taken out for five years or until age 59.5, whichever is later, REGARDLESS of market conditions. If you do not stick to your 72(t) payment plan, the distributions will no longer qualify for the exemption from the early distribution, and the 10% penalty will apply. The penalty will apply not only to distributions moving forward, but all prior distributions will be subject to this penalty retroactively.
Why is stock market volatility significant? Many folks used this strategy leading up to the 2008 financial crisis based on their entire IRA and/or 401k balance. Because of the market pullback, they ran out of retirement funds to satisfy these distributions from their accounts. The IRS still required the distributions to be satisfied, plus they were taxed, and penalties were assessed for the missed distribution. Because of the unusual circumstances, the IRS did come up with a pardon. However, this can't be relied upon for instances like this moving forward. It is important to note that you are also allowed a one-time-only change from either the annuitization, amortization method, or the RMD method during your distribution years.
As you can sense, Rule 72(t) distributions can be very powerful in the right circumstances. That said, there are many considerations before implementing this strategy. If you are exploring this as a strategy and would like to discuss how this may help you and fit into your specific retirement plan, we would be happy to chat with you about your options. Get in touch with us by clicking the button below!