By Andy Ives, CFP®, AIF®
Do you want to access your IRA funds penalty-free, even though you are under age 59 ½ and no exception fits your situation? It can be done. Starting a new business and need capital from your IRA, but don’t want to pay the 10% early withdrawal penalty? There is a workaround. Lost your job and require funds to cover your mortgage and cell phone bill, but the only bucket of cash you have is your IRA? There is a pathway to the gold, but it is fraught with danger.
Like Indiana Jones sprinting through spiderwebs and dodging poison-tipped darts while leaping bottomless pits, the giant 72(t) boulder will roll fast at your heels. One misstep could result in crushing disaster. However, if it is the golden idol in the rear of the IRA cave you seek, there is a way.
The general idea of a 72(t) schedule (or a “series of substantially equal periodic payments”) is to open the door to an IRA before 59½ without a 10% penalty. However, you must commit to a plan of withdrawals according to the rules set out in Section 72(t) of the Internal Revenue Code. For example, you can begin the payment schedule from an IRA at any age, but it is required to continue for at least five years or until age 59½, whichever period is longer. (Start at age 42, and your daring cave escape must last 17+ years.)
The payments cannot be stopped during the term, unless the account owner becomes disabled, dies, or the account is decimated (say, from poor investment decisions). The IRA account to which the 72(t) schedule applies cannot have dollars added to it via contributions or rollovers. As such, consider splitting the IRA account prior to entering the 72(t) cave – the restrictions will only apply to the IRA being annuitized.
If you think you can avoid the thundering boulder by rolling over any unneeded 72(t) payments to a different IRA, that dead end will send you straight into the spears of the IRS. 72(t) payments are not eligible for rollover. Also, if the agreed upon schedule is modified, or if the balance in the IRA changes from anything other than normal gains and losses, then the 10% penalty will apply retroactively to all distributions taken prior to age 59 ½. More spears.
So how does one calculate the amount of the 72(t) payment? The IRS describes three primary allowable methods: Minimum Distribution, Amortization, and Annuity Factor. The Minimum Distribution method is essentially calculated in the same manner as RMDs when a person reaches his required beginning date. This method will generally produce the lowest annual payment, and it will fluctuate as the account balance and age factor change from year to year.
The Amortization and Annuity Factor Methods will produce higher annual withdrawals. Both methods allow you to use a “reasonable” interest rate to calculate the payment schedule. The IRS describes a reasonable interest rate as, “any interest rate that is not more than 120 percent of the federal mid-term rate…for either of the two months immediately preceding the month in which the distribution begins.”
Be wary. This is only a brief overview of the 72(t) process. Understanding the danger zones is paramount to survival. Read the cave map carefully, know the risks, and stay out of the light. By following the rules, you may get some spiderwebs stuck to your arms, but at least you can walk away with your golden 72(t) idol in hand.