72t Distributions for Early Retirement

Rule 72t dis­tri­b­u­tions are used to avoid a penal­ty when IRA own­ers need mon­ey from their IRAs ear­ly.

72t distributions

Enjoy an Ear­ly Retire­ment With Rule 72t Dis­tri­b­u­tions © Can Stock Pho­to

This site is a a lit­tle tech­ni­cal and was cre­at­ed as a resource for finan­cial advi­sors and finan­cial plan­ners. Con­sumers may want to vis­it our con­sumer site on IRA dis­tri­b­u­tions. Finan­cial advi­sors will find some of the more tech­ni­cal issues here such as exact­ly how sec­tion 72t dis­tri­b­u­tions are imple­ment­ed, how to take dis­tri­b­u­tions from just one IRA account if the client has sev­er­al and what hap­pens if your client miss­es a dis­tri­b­u­tion. Finan­cial advi­sors and finan­cial plan­ners may also want to send their clients and prospects a newslet­ter that can be focused on IRA dis­tri­b­u­tion and man­age­ment issues.

The IRS per­mits ear­ly retirees to access their retire­ment funds pri­or to age 59 12 with­out penal­ty as long as they take dis­tri­b­u­tions under a plan of sub­stan­tial­ly equal­ly peri­od­ic pay­ments (rule 72t dis­tri­b­u­tions). Once start­ed, these pay­ments must con­tin­ue for the longer of 5 years of their attain­ment of age 59 12. There­fore, once a 72t dis­tri­b­u­tion plan is start­ed, these become required manda­to­ry dis­tri­b­u­tions sub­ject to the ear­ly with­draw­al penal­ty if ceased.

How to Calculate Section 72t Distributions

With peo­ple build­ing up large amounts in IRAs and tak­ing ear­ly retire­ment, you’re going to run into sit­u­a­tions when clients 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. 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.

The pay­ments must con­tin­ue for five years or until your client 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.

And in case clients 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.

Each IRA stands on it own. Mean­ing that tak­ing 72(t) dis­tri­b­u­tions from one account has no effect on the oth­ers. There­fore, if one IRA will pro­duce more income than is need­ed, you could have your client set up a small­er, seg­re­gat­ed account to for with­drawals. And in the future, if she needs more income, she could begin equal dis­tri­b­u­tions from anoth­er IRA account as well. This could pro­vide greater flex­i­bil­i­ty in meet­ing your clients’ imme­di­ate and future income require­ments.

Tip: Say your client has $600,000 in a IRA. But one of the 72t dis­tri­b­u­tion meth­ods below will sup­ply the clien­t’s income needs based on a $200,000 IRA.  Divide the IRA into three $200,000 IRAs.

Three ways to calculate 72t distributions

The Min­i­mum Dis­tri­b­u­tion Method is cal­cu­lat­ed the same way as required min­i­mum dis­tri­b­u­tions when account own­ers reach their required begin­ning dis­tri­b­u­tion date. This method will gen­er­al­ly pro­duce the low­est annu­al 72(t) pay­ments since it is based on the longest life expectan­cy. The required min­i­mum dis­tri­b­u­tion method con­sists of an account bal­ance and a life expectan­cy (sin­gle life or uni­form life or joint life and last sur­vivor each using the age(s) attained in the year for which dis­tri­b­u­tions are cal­cu­lat­ed). The annu­al pay­ment is pre­de­ter­mined for each year.

This is the sim­plest of meth­ods to cal­cu­late and allows clients to take advan­tage of growth in their accounts and cre­ate larg­er pay­ments in future years. How­ev­er, a decline in the IRA bal­ance will reduce future 72t dis­tri­b­u­tions.

The Fixed Amor­ti­za­tion Method con­sists of an account bal­ance amor­tized over a spec­i­fied num­ber of years equal to life expectan­cy (sin­gle life or uni­form life or joint life and last sur­vivor) and a rate of inter­est that is not more than 120 per­cent of the fed­er­al mid-term rate pub­lished in rev­enue rul­ings by the Ser­vice. Once an annu­al dis­tri­b­u­tion amount is cal­cu­lat­ed under this fixed method, the same dol­lar amount must be dis­trib­uted in sub­se­quent years.

This pro­duces high­er pay­ments than the Min­i­mum Dis­tri­b­u­tion Method and gives some secu­ri­ty in that the pay­ments are fixed. But the cal­cu­la­tion is com­pli­cat­ed and there is the risk that the pay­ments will not keep pace with infla­tion.

The Fixed Annu­iti­za­tion Method con­sists of an account bal­ance, an annu­ity fac­tor, and an annu­al pay­ment. The age annu­ity fac­tor is cal­cu­lat­ed based on the mor­tal­i­ty table in Appen­dix B of Rev. Rul. 2002–62 and a rate of inter­est that is not more than 120 per­cent of the fed­er­al mid-term rate pub­lished in rev­enue rul­ings by the Ser­vice. Once an annu­al dis­tri­b­u­tion amount is cal­cu­lat­ed under this fixed method, the same dol­lar amount must be dis­trib­uted under this method in sub­se­quent years.

The rev­enue rul­ings that con­tain the fed­er­al mid-term rates may be found at http://www.irs.gov/taxpros/lists/0„id=98042,00.html.

This method may at times pro­vide the largest pay­ments, depend­ing on the size of the account and inter­est rates used. And like amor­ti­za­tion method, the pay­ments are fixed.

It is, how­ev­er, the most com­pli­cat­ed method to use. The IRS’s Annu­ity Fac­tor table is not as easy to use as the life expectan­cy fac­tors from IRS Pub­li­ca­tion 590. How­ev­er, there are com­put­er pro­grams avail­able that con­tain the actu­ar­i­al table used for the Annu­ity Fac­tor Method.

Brentmark’s Soft­ware Pen­sion & Roth IRA Ana­lyz­er is one pro­gram that will do the cal­cu­la­tions for you.

Oth­er help­ful sources are: http://72t.net/

Case Study

Harold is 50-years-old, has an IRA that is worth $400,000 (end of year) and wants to take income from the account with­out pay­ing the 10% penal­ty. His advi­sor will use 4.5% as 120% of the fed­er­al mid-term rate and the sin­gle life expectan­cy table to cal­cu­late his client’s dis­tri­b­u­tion options.

Required Min­i­mum Dis­tri­b­u­tion Method

The annu­al dis­tri­b­u­tion amount ($11,695.91) is cal­cu­lat­ed by divid­ing the end of year account bal­ance ($400,000) by the sin­gle life expectan­cy (34.2).

$400,000/34.2 = $11,695.91

For sub­se­quent years, the annu­al dis­tri­b­u­tion amount will be cal­cu­lat­ed by divid­ing the account bal­ance as of Decem­ber 31 of the pri­or year by the sin­gle life expectan­cy obtained from the same sin­gle life expectan­cy table using the age attained in the year for which dis­tri­b­u­tions are cal­cu­lat­ed.  For exam­ple, if Harold’s IRA account bal­ance, after the first dis­tri­b­u­tion has been paid, is $408,304 on Decem­ber 31, the annu­al dis­tri­b­u­tion amount for next year ($12,261.38) is cal­cu­lat­ed by divid­ing the Decem­ber 31 account bal­ance ($408,304) by the sin­gle life expectan­cy (33.3) obtained when an age of 51 is used.

$408,304/33.3 = $12,261.38

Fixed Amor­ti­za­tion Method

For the first year, the annu­al dis­tri­b­u­tion amount will be cal­cu­lat­ed by amor­tiz­ing the account bal­ance ($400,000) over a num­ber of years equal to Harold’s sin­gle life expectan­cy (34.2) when an age of 50 is used at a rate of inter­est equal to 4.5%.  If an end-of-year pay­ment is cal­cu­lat­ed, then the annu­al dis­tri­b­u­tion amount is $23,134.27.  Once an annu­al dis­tri­b­u­tion amount is cal­cu­lat­ed under this fixed method, the same amount will be
dis­trib­uted under this method in sub­se­quent years.

Fixed Annu­iti­za­tion Method

Under this method the annu­al dis­tri­b­u­tion amount is equal to the account bal­ance ($400,000) divid­ed by the cost of an annu­ity fac­tor that would pro­vide one dol­lar per year over Harold’s life, begin­ning at age 50 (i.e. the actu­ar­i­al present val­ue of an annu­ity of one dol­lar a year payable for the life of a 50 year old).  The age 50 annu­ity fac­tor (17.462) is cal­cu­lat­ed based on the mor­tal­i­ty table in Appen­dix B of Rev. Rul. 2002–62 and an inter­est rate of 4.5%.  Such cal­cu­la­tions would nor­mal­ly be made by an actu­ary.

The annu­al dis­tri­b­u­tion amount is cal­cu­lat­ed as $400,000/17.462 = $22,906.88

Once an annu­al dis­tri­b­u­tion amount is cal­cu­lat­ed under this fixed method, the same amount will be dis­trib­uted under this method in sub­se­quent years.

Case Study

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) dis­tri­b­u­tions?

The three dis­tri­b­u­tion options would require that Heather com­mit the fol­low­ing amounts for Sec­tion 72(t) 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) 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 mon­ey from her oth­er IRAs with­out pay­ing the 10% penal­ty after she turns 59 ½.