Thursday, April 9, 2015

72T Retire Early

Wednesday, April 8, 2015

Some of you out there may be interested in how to retire early using Rule 72t, or 72(t) of the internal revenue code. As you all know, if you take money out of your 401k or other tax-deferred retirement accounts prior to age 59 1/2, you will not only be taxed on that distribution as ordinary income, but you’ll also pay an additional 10% penalty tax on top of that.  After you add on state taxes, you could end up losing more than 1/2 of your withdrawal to taxes.

Rule 72t provides an exception to the 10% penalty tax so that you can avoid it, as long as you follow some straitforward guidelines in taking these early withdrawals.  Another name for Rule 72t is “substantially equal periodic payments (SEPPs).

The requirements for taking SEPPs are fairly simple.  You can begin taking SEPPs out at any age, but you have to continue taking out the same amount (at least annually) for at least 5 years, or till age 59 1/2, whichever comes later.  You have to make sure you do the following things:
  • You need to take out the payments at least once per year
  • The payments much be calculated according to one of the IRS-approved methods for determining SEPPs
  • You cannot make contributions, transfers (in or out) or rollover into the account from which you are taking SEPPs, nor can you take extra withdrawals from that account.
While these 72t rules are fairly simple, the penalties for not following them are severe.  If you don’t follow these rules, the entire amount that you take out prior to age 59 1/2 may be subject to a retroactive application of the 10% early withdrawal penalty, plus interest.
What are the IRS-approved calculation methods?
There are 3 IRS-approved methods for calculating SEPPs, or 72t distributions.  Keep in mind that once you choose a method of calculation and determine a payment, you cannot change that withdrawal amount for 5 years, or until age 59 1/2, whichever comes later.

Amortization method
The amortization method requires that a “reasonable” rate of interest* be used in the calculation.  Using your retirement account balance (generally as of 12/31 of the year before you start the 72t plan) and the account owners single life expectancy (or joint life expectancy of the account owner and a beneficiary) taken from IRS life expectancy tables, this method calculates the equal payments that can be taken.

Annuity method
Using the annuity method, distribution amounts are calculated by dividing the retirement account balances by an annuity factor based on the account owner’s single life expectancy and a reasonable rate of interest*.  This method essentially turns your retirement account into a lifetime stream of income payments.  Like the amortization method, these 72t payments must remain the same from year to year.
MRD method

The MRD method recalculates your payment every year.  The annual payment is generally the 12/31 account balance divided by the life expectancy from the applicable IRS Life Expectancy Table, based on your age or the age of your beneficiary.  Because the MRD method recalculates the distribution amount every year, this method reacts to teh changes in your overall account balance, so you are less likely to rapidly deplete your account if the balance has dropped due to market decline.
*Note:  IRS guidance provides that the interest rate that may be used is one that is not more than 120% of the federal mid-term rate for either of the two months immediately preceding the month in which payments begin.