If you’ve got tax-advantaged retirement accounts like an IRA, 401(k), or 403(b) plans, then you should be aware of Rule 72(t). One of the reasons these accounts offer so many tax benefits is that you don’t have access to your own money while the government is using it — and until you’ve pretty much reached retirement age (59 and a half, to be precise).
While the IRS does allow you to withdraw money from your retirement accounts early, you’ll typically have to pay a substantial penalty amount, unless you are in extreme circumstances and/ or you meet certain requirements.
It’s always a smart strategy to be aware of your financial options just in case the unthinkable happens, so read on for more details on how this relatively obscure IRS subsection might one day help your family during a difficult situation or if you’re ready to go ahead and retire early.
What is Rule 72(t)?
It’s a section of the Internal Revenue Code that explains the process for making an early withdrawal from your qualifying retirement accounts without paying the 10% additional tax, as long as you follow a variety of guidelines.
Here are several common exemptions to the premature distribution tax that fall under this section:
- Permanent disability of the IRA owner
- A qualified Domestic Relations Order
- Qualified higher-education expenses
- Qualified first-time homebuyers
- Certain medical expenses
- Health insurance premiums paid while unemployed
- Qualified military reservists called to active duty
If you’re not considered to meet any of the above requirements, then you’ll need to file paperwork to set up a series of substantially equal periodic payments (SEPPs) through Rule 72(t) to avoid that higher tax payment.
SEPPs and Early Retirement
People choose to retire early for a myriad of reasons, from poor health to wanting to spend more time with their family or finally writing that novel. It’s fabulous if you’re able to pull it off — but will you have enough money to be comfortable over an extended period? An experienced financial advisor can help you go over all of your options.
What’s an SEPP exactly?
And why does it matter? SEPP withdrawals are not allowed if you are still working for the same employer. Once you set up one of these plans, it must continue for a minimum of five years, or until you’re almost 60, whichever comes later. If you’re still relatively young, setting up an SEPP might not be the best choice for you.
The IRS dictates that there are 3 approved ways to calculate the amount of your SEPP withdrawal, and they can result in varying annual receivables:
Required Minimum Distribution
This is a relatively simple if somewhat morbid approach that delivers a variable annual income. It is determined per tax year by dividing the current account balance by the owner’s current life expectancy which is obtained through one of three IRS tables. A new calculation must be run each year. The ROI on your investment account will significantly affect the payment amount.
This method is the one to choose if you want a consistent yearly payout. When the plan begins, the amount is calculated by amortizing the balance over a set number of years, once again based on those lovely IRS life expectancy tables, and affixed with a chosen interest rate. The payment will not be affected by any returns subsequently invested in the account.
Also resulting in an equal payment per year, this more complicated method is figured by dividing the starting account balance by an annuity factor. This is based on the mortality table in Appendix B of Rev. Rul. 2002-62 and an interest rate of not more than 120% of the federal mid-term rate.
The only time the IRS does not enforce retroactive penalties for modifying an SEPP plan is if the funds in the account are completely exhausted.
Besides setting up an SEPP, there are other expenses that qualify for an early disbursement from your retirement plan without the penalty fee, as mentioned above.
While you can use higher education expenses as an excuse to make a withdrawal, the only ones that count as far as the IRS is concerned are tuition, fees, books, and supplies. If you withdraw from an IRA to make school-related expense payments, this is taxable income and could affect future financial aid eligibility. It’s not advisable to use your retirement accounts as a college fund.
First-time homebuyers may receive up to $10,000 per person or $20,000 per couple from IRA accounts to help pay for buying or building a house for yourself, your children, or your grandchildren. As always, there’s a catch — you can only enjoy this benefit if you qualify under the IRS rules.
If you or your spouse is called to active duty, the IRS is happy to waive the 10% early withdrawal penalty. There are many unforeseen costs associated with these sudden life changes, and many military families don’t have adequate savings.
The Bottom Line
Most experts recommend that you explore pretty much any other option before deciding to raid your retirement fund. It’s usually best if your assets stay tucked away in tax-advantaged investments so they’re safe for your golden years.
But of course things happen, and that’s why certified financial professionals are here to help you make the best decisions for you and your family. The world is changing rapidly, so why not trust someone who’s experienced in building financial stability?
If you’re considering making an early withdrawal from your retirement accounts and want to know more about Rule 72(t) and the options available to you, reach out to our expert team at Sustainable Retirement Income today!