By Andy Ives, CFP®, AIF®
The 72(t) rules (”series of substantially equal periodic payments”) allow a person to tap retirement dollars before 59½ without a 10% early distribution penalty. However, to gain this early access, you must commit to a plan of withdrawals according to the strict guidelines set forth in the Tax Code. For example, some basic requirements dictate that:
- 72(t) payments can begin from an IRA at any age, even if you are still working.
- 72(t) payments from a company retirement plan are permitted only if the person has terminated employment with that company.
- Must continue for at least five years or until age 59½, whichever period is longer.
- Must be distributed at least annually.
If you get sideways with the rules, a 10% penalty will apply retroactively to all distributions taken before age 59 ½, sometimes referred to as the “recapture penalty.” To avoid this retroactive penalty, here are a handful of important “72(t) Don’ts” to consider:
Don’t roll new money into the IRA account with the 72(t), and don’t make any contributions to that IRA. Both actions will be deemed as a modification of the account and will trigger the recapture penalty. Think of the IRA with the 72(t) as a fragile antique bowl filled to the rim with a volatile and explosive liquid. Those who start a 72(t) must carry this delicate bowl with them until the 72(t) term expires. Handle it with extreme caution!
Don’t think you can withdraw more than what the 72(t) payment structure allows. Sure, the IRS would get their taxes quicker if you took larger distribution, but this is a deviation from the 72(t) term and will be a modification.
Don’t handcuff all your IRA money. If the desired annual payout can be achieved with a lower starting IRA value, it is highly recommended that you split the IRA. The strict 72(t) rules (the “handcuffs”) will only apply to the IRA being annuitized. The IRA without the 72(t) can still be used for contributions, Roth conversions, rollovers, additional withdrawals, etc.
Don’t alter the payment formula – stick to the script. While there is a one-time change allowed from the amortization and annuitization methods to the RMD method, be careful. Do not slosh the volatile 72(t) liquid around too much in the antique bowl.
Don’t stop the payments. Unless you die or become disabled, stopping the payments is a modification and will activate the recapture penalty.
Don’t shortchange yourself with a low interest rate. The IRS recently permitted the use of 5% for new 72(t) calculations if applicable rates are lower. However, in a rising interest rate environment, it is imperative to be aware of current rates so as to maximize new 72(t) schedules.
Don’t get loose with the 72(t) rules. Carry that fragile bowl carefully. Do not spill a drop of the volatile liquid. Any misstep or modification will trigger the recapture penalty…and the 72(t) will explode.