There is an obscure IRS code referred to as “the 72t rule” that can help you make early IRA withdrawals penalty free. Let’s say you want to retire now but you need more income. Further, assume you’d like to tap into your IRA before reaching age 59 ½ and not pay any tax penalties. The good news is that you can do this.
(Keep in mind that this is something you have to be very careful about. If you exhaust your IRA, you may be forced to go back to work. That’s why it’s critical to know how much money you need to retire and plan accordingly.)
What is the 72t exception?
It simply states that if you make a series of “substantially equal periodic withdrawals” from the IRA, you won’t be subject to the 10% penalty, even if you are under age 59 ½. So you can generate retirement income even though you aren’t 59 1/2!
The withdrawals must be made at least annually but can be taken more frequently (like monthly). They have to be made for your life expectancy or the joint life expectancy of you and your beneficiary.
You can use one of three methods to calculate your “substantially equal periodic withdrawal.”
1. The life expectancy method. This uses the minimum distribution rules.
2. The amortization method. This uses your life expectancy and a reasonable interest rate determined by the IRS.
3. The annuitization method. This takes your account balance and divides it by an annuity factor. The annuity factor is determined using your life expectancy plus an interest rate.
If you do decide to make this election, you would speak to your IRA custodian to determine the amounts that either election would provide and then take decide which amount suits you best.
Your custodian will ask you to complete a form, and you should keep a copy just in case the kids at the IRS get frisky and want to give you a hard time. You should also keep a copy of your investment statements that you used to determine the amounts of the payments.
When your custodian sends you your payments, they’ll also provide you with a 1099 at the end of the tax year. Hopefully, they’ll code it appropriately so you won’t have to do anything else. If they don’t, you’ll have to file IRS Form 5329 to claim the exemption to the 10% penalty.
If you have several IRAs, you don’t have to apply this rule to ALL your accounts. You can simply use this exception to tap into as few or as many IRA accounts as you like. But there are some IRA restrictions. Once you make your election, the entire balance of that account will be used to calculate your distributions.
Once you do make your election, you have very little control over the payments. You can make adjustments for cost of living, but that’s about it. The payments have to continue for the greater of five years or until you reach age 59 ½. So, if you start this when you are 40, you have to take the payments until you reach 59 ½, which is in 19 ½ years. If you start this when you are 58, you have to keep taking those payments until you reach age 63, which will be five years later.
Once you take payments for the minimum number of years, you can change the amount or stop the payments completely. Use the IRS Form 89-25 to calculate your payments.
The benevolent folks at the IRS do allow you to make changes to your payments if you use the Amortization or Annuitization method without a penalty. But other than that, if you make changes, you’ll face penalties for making changes to the schedule. However, if you use the Minimum Distribution method, your payments will automatically be recalculated each year.
And while we’re at it, make sure to double-check your math. If you make a mistake and don’t take the correct amount, you could be clobbered by the IRS in penalties. Keep in mind that the 72t rules don’t apply if you over-contribute. What happens if you contribute too much to an IRA is an entirely different story.
Have you used the 72t rule to tap your IRA? Why or why not?