Rule of 72(t)

Rule 72(t) offers an exception to the 10% early withdrawal penalty for accessing funds before age 59½. It outlines three methods for calculating the required amount as part of a series of Substantially Equal Periodic Payments (SEPP).

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    Barbara O’Neill, Ph.D. CFP®, AFC®, CRPC®

    Barbara O’Neill, Ph.D., CFP®, AFC®, CRPC®

    Owner and CEO of Money Talk

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  • Updated: July 11, 2024
  • 5 min read time
  • This page features 3 Cited Research Articles

Key Takeaways

  • Early distributions from retirement accounts typically incur a 10% penalty in addition to regular income tax.
  • Rule 72(t) provides an exception to the early distribution penalty when withdrawals follow one of three prescribed methods as part of a series of Substantially Equal Periodic Payments.
  • Rule 72(t) allows early access to retirement funds, but this comes with certain risks.
  • Before opting for Rule 72(t), ensure you have sufficient savings.

Retirement accounts like IRAs and 401ks provide you with a tax-advantaged way to save for retirement. In order to take full advantage of the tax benefits, however, there are certain rules you need to follow.

This is especially true concerning withdrawals. If you fail to follow the rules, you could be faced with additional penalties. One common example is the 10% early withdrawal penalty that will apply to most distributions from tax-deferred retirement accounts taken before the account owner turns 59½. Fortunately, rule 72(t) provides for certain exceptions. 

If you need to withdraw from your retirement savings before turning 59½ , it’s important that you understand rule 72(t) and the options it provides you.

What Is Rule 72(t)?

When someone refers to rule 72(t), they are specifically referring to section 72(t)(2)(A)(iv). This section allows you to withdraw from your tax-deferred retirement savings accounts before 59½ without incurring an additional 10% penalty by establishing a series of Substantially Equal Periodic Payments (SEPP).

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How To Calculate SEPP Under Rule 72(t)

In essence, a substantially equal periodic payment under Rule 72(t) is a recurring payment that remains consistent.

To satisfy the “periodic” component, you must take a distribution at least annually once you begin. You must continue taking that distribution for the longer of 5 years or until you turn 59½.

Instead of leaving you to determine what constitutes “substantially equal,” the IRS offers three distinct approaches to calculate your withdrawals. Following any of these formulas ensures that your payments meet the “substantially equal” requirement.

Method 1: Required Minimum Distribution (RMD)

Under this method, your required withdrawal is computed similarly to how you determine your Required Minimum Distribution (RMD). You divide your account balance as of December 31st by your remaining life expectancy, using the appropriate IRS table for either single or joint life with your spouse. 

The key to correctly following this approach is understanding that the actual dollar amount of your distribution will vary each year. As long as you adhere to the formula and make your annual distribution, you will meet the requirements of Rule 72(t).

Method 2: Amortization

This method requires you to essentially treat your account balance like a loan, with the withdrawal calculated as though it were a payment that would pay your balance off over your life expectancy. You can choose an interest rate not more than the greater of 5% or 120% of the federal mid-term rate. Unlike the RMD approach, the dollar amount of your withdrawal does not change once it is established.

Method 3: Annuitize

To determine your SEPP under the annuity method, first calculate the present value of a $1 annuity given your life expectancy, and an interest rate not more than the greater of 5% or 120% of the federal mid-term rate. This allows you to annuitize your account balance, giving you an annuity factor. Divide your account balance by this annuity factor. Like the amortization method, the dollar amount of your withdrawal remains fixed.

Rule 72(t) of the tax code can be both a blessing and a curse. On the plus side, it provides an opportunity for penalty-free early withdrawals from traditional IRAs and qualified plans. However, there are downsides, including complex calculations (amortization and annuitization methods), strict withdrawal rules and the risk of prematurely depleting retirement savings.

It is important to weigh 72(t) withdrawals against other sources of income and other withdrawal penalty exceptions (e.g., disability, medical expenses, first-time home buying and employment ending after age 55). Consulting a financial advisor is advisable to ensure withdrawals are set up correctly.

Example Calculations of SEPP Withdrawals Using Different Methods

Assume you have $800,000 in your account, and want to use 3% as your interest rate. You are 55 years old so your life expectancy according to the Uniform Lifetime Table is 43.6 years.

Refer to the image below for an outline of the withdrawal amounts under each method:

Infographic showing rule 72(t)

Benefits and Drawbacks of Rule 72(t)

As with all financial decisions, choosing to use Rule 72(t) offers both benefits and potential risks.

The main benefit of Rule 72(t) is that it allows you to access your tax-deferred retirement funds before age 59½ without incurring the additional 10% penalty. This can potentially be the deciding factor in whether you can retire early.

However, there are potentially significant downsides. Withdrawing from your retirement accounts too early could deplete your funds if not planned carefully. Additionally, once you begin SEPP distributions, you cannot deviate from the payment schedule until five years have passed and you turn 59½. If you do, all your previous withdrawals will be subject to the early withdrawal penalty. Therefore, it’s crucial to proceed with caution.

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Application of Rule 72(t)

There are times when Rule 72(t) can be quite helpful. For example, if you’ve saved enough to retire early, avoiding the 10% penalty allows you to keep more of your money. However, since you must continue making SEPP distributions for at least five years, Rule 72(t) is generally not suitable for covering short-term expenses or emergencies, for which a dedicated savings account would be better suited.

Rule 72(t) allows you to avoid the 10% early withdrawal penalty when accessing retirement savings before age 59½. However, there are significant pitfalls to consider, such as strictly adhering to your SEPP schedule.

Given the steep penalties for not following the rules, it’s essential to consult your tax and financial advisor before making any decisions.

Frequently Asked Questions

When can I begin taking withdrawals under rule 72(t)?

Rule 72(t) allows you to start taking Substantially Equal Periodic Payments at any time. However, once you begin, you must continue until you turn 59½ or five years have passed, whichever is longer.

What is the penalty if I modify my SEPP schedule?

Failure to follow the SEPP withdrawal rules, including modifying your distributions, results in the entire amount you’ve withdrawn becoming subject to the 10% penalty plus interest. The one exception is that you are allowed to make a one-time switch from the annuitization or amortization method to the RMD method.

What if I withdraw my entire balance before 5 years?

If you deplete your entire balance by following one of the prescribed distribution methods before five years have passed, you will not be able to maintain your SEPP distribution schedule. In this case, the 10% penalty will not apply to the current year distribution or any previous distributions.

Still have questions?

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: July 11, 2024
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