IRA Distributions for Early Retirees - Rule 72t
With people building up large amounts in IRAs and taking early retirement,
people want to tap into their retirement accounts before they reach age 59½.
The problem is, though, that they’ll have to pay the 10% early withdrawal
penalty on their IRA distributions. Fortunately, there is a way around this.
Section 72(t) of the Internal Revenue Code allows taxpayers of any age to
take a series of substantially equal periodic payments without a 10% penalty.
These IRA distribution payments must continue for five years or until the
IRA owner reaches 59½ years old, whichever period is longer. While
they are receiving the money, they cannot make any changes to the payments.
However, they can irrevocably switch one time to the RMD method (see below).
And in case IRA owners do not stay with the plan, or modify the payments in
any way, they will no longer qualify for the exemption from the 10% penalty. Furthermore,
the 10% penalty will be reinstated retroactively, to all prior years' IRA distributions.
Each IRA stands on it own, meaning that taking 72(t) IRA distributions from
one account has no effect on the others. Therefore, if one IRA will produce
more income than is needed, you could set up a smaller, segregated account
to withdraw from. And in the future, if you need more income, you could begin
equal distributions from another account as well. This could provide greater
flexibility in meeting your ’immediate and future IRA distribution requirements.
There are three ways to calculate 72(t) IRA distributions and the selection
gives taxpayers some flexibility.
An example of rule 72t applied:
Heather has $1 million in her IRA, is 57, and wants to retire. She’ll
have enough to live on once Social Security starts at age 62. However, until
that time, she will need an additional $12,000 per year to meet her living
expenses. The IRA is her only investment asset. But she doesn’t want
to pay the 10% penalty on early withdrawals for the next 2½ years. How
much should Heather convert for section 72(t) IRA distributions?
The three distribution options would require that Heather commit the following
amounts for Section 72(t) IRA distributions:
- Minimum Distribution Method - $334,800
- Fixed Amortization Method - $188,520
- Fixed Annuitization Method - $189,600
Since Heather does not want to withdraw any more than necessary, segregating
$188,520 and using the Fixed Amortization Method for Section 72(t) IRA distributions
is the most desirable strategy. This will give her $12,000 per year for five
years until her Social Security begins.
Plus she’ll have the flexibility to take IRA distributions from her
other IRAs without paying the 10% penalty after she turns 59 ½. And
over the next 5 years, should she find she needs more income, she can segergate
another IRA from her total IRA assets and place it on a 72t IRA distribution
program.
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