How to Take Penalty-Free Early Withdrawals from Retirement Accounts
Money Girl answers a listener question about a little-known exception to take early withdrawals from a retirement account and avoid having to pay a steep penalty.
Laura Adams, MBA
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How to Take Penalty-Free Early Withdrawals from Retirement Accounts
I received this question from Glenn:
“In one of your podcasts about IRAs, you mentioned the penalty for taking an early withdrawal if you’re younger than age 59½. But what if you want to retire early—is the 72(t) exception still an option?”
In this episode, I’ll explain the little-known and oddly-named exception that Glenn mentions. You’ll learn how to take withdrawals early and avoid having to pay a steep penalty.
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What Is an Early Withdrawal from a Retirement Account?
If you’re a regular Money Girl reader or podcast listener, you know that I strongly recommend using retirement accounts, such as IRAs and workplace plans to save for retirement. They come with terrific tax benefits and legal protections that don’t come with regular investing accounts.
However, retirement accounts also have a major downside: you generally can’t take money out of one before age 59½ without having to pay a 10% penalty. The idea is that these accounts are meant to provide security in retirement and not to be tapped early or on a whim.
There are some qualified exceptions when you can take early distributions from an IRA that are penalty-free, such as paying for education, medical bills, or for your first home. You can see all the rules for popular types of accounts on my handy one-page download called the Retirement Account Comparison Chart.
See also: 3 Common IRA Mistakes That Steal Your Wealth
What Is a 72(t) Payment Plan?
In addition to a few allowable situations, there’s also a little-known rule you can use to avoid the early withdrawal penalty. Problem is, it comes with restrictions and some risky consequences if you don’t use it the right way.
This exception goes by a few different names, such as a 72(t) distribution, a 72(t) payment plan, substantially equal periodic payments, or a SEPP plan. The name 72(t) comes from its numbered section of the IRS tax code.
This regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) from a workplace plan, such as a 401(k) or 403(b), as long as you no longer work for your employer.
The amount you can withdraw using a 72(t) plan is calculated using one of 3 accounting methods approved by the IRS. I won’t bore you with the details of figuring substantially equal periodic payments, but some of the factors that go into the calculations include your account balance, age, and life expectancy.
It’s important to understand that once you begin taking 72(t) distributions, you can’t stop taking them for a certain period of time.
The payment calculation can be based on the amount in a single retirement account instead of the aggregate of all your retirement accounts. You can set up multiple accounts in order to have more control over the distribution amount you must take.
All payments you receive from a 72(t) plan that weren’t previously taxed, such as for a traditional IRA or traditional 401(k), will be subject to income tax, just like when you take distributions from those accounts in retirement.
It’s important to understand that once you begin taking 72(t) distributions, you can’t stop taking them for a certain period of time. Once the plan is put in place you must take the periodic payments for a minimum of 5 years or until you turn 59½, whichever is longer.
After you complete a series of 5-year distributions and reach the age of 59½, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 70½, you generally must take annual required minimum distributions, no matter if you used a 72(t) plan or not.
Another issue with initiating a 72(t) payment plan is that you can’t make any new contributions to your retirement account or add any assets or rollovers while taking payments.
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Who Can Benefit from a 72(t) Payment Plan?
You’re probably wondering who should use a 72(t) plan and if it could ever be right for you.
It’s a huge benefit if you’re ready to retire before the official age of 59½, or if you really need to supplement your income. It’s a great way to start spending your retirement funds without having to pay expensive early withdrawal penalties.
Let’s say you get downsized from your job at age 50 and decide to transition into a less lucrative career or to work part-time. If you need additional income, you could set up a 72(t) plan and take substantially equal periodic payments until you reach age 59½.
When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount.
Remember that once you hop on the 72(t) payment train, the ride must last for 5 years or until you turn 59½, whichever is longer. So, after receiving payments for 9½ years, from age 50 to 59½, you could stop taking payments. Or you could keep the distributions coming in the same amount or even change it to any amount you like.
Another scenario is when you accumulate plenty of money for retirement ahead of time and want to use it to pay down debt or to make gifts to charities or family members. You could use 72(t) payments to tap your retirement account early, without penalty.
When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount.
Taking too little, too much, or missing a distribution deadline can result in expensive consequences. In addition to owing income tax, messing up your 72(t) payments means that all of your distributions will be subject to the 10% early withdrawal penalty—plus, interest on unpaid tax and penalties calculated from the original date you made an error. Ouch!
Therefore, always get help from a tax professional who has experience setting up a 72(t). Weigh all your options carefully and never enter into a 72(t) plan lightly. Ask yourself if you really need the money or have other sources to tap.
Make sure you can afford to trade your nest egg for an immediate cash flow. Taking payments now means that you drain the resources available to you later on in retirement.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.