There are many reasons why a person may want or need to take withdrawals from their IRA before they reach retirement. However, so-called “early withdrawals” can have a big impact on your taxes, subjecting you to taxes on the withdrawn amount as well as a 10% tax penalty. There are several ways to avoid this penalty, and IRS code 72(t) is one of them. Let’s look at what is 72(t) rule, and how to avoid early IRA withdrawal penalties using rule 72(t).
What is the 72(t) rule?
The 72(t) rule refers to the Internal Revenue Code, section 72, subsection T. Subsection T includes a number of exceptions to the 10% tax penalty. However, when most people refer to “rule 72(t)”, they are referring to the exception available when you choose to set up your withdrawal using the SEPP method.
What are SEPPs?
SEPP stands for Substantially Equal Periodic Payments. When you use Rule 72(t) for early withdrawals from a retirement account, setting up SEPPs allows you to avoid the 10% tax penalty. When you set up an SEPP, you must schedule a series of withdrawals, at least annually, for five years or until you turn 59 ½. If you miss an installment on this withdrawal schedule, you owe the tax penalty on all withdrawals made up to that point.
Setting up SEPPs is complex. The withdrawal amount is based on the amount of savings in your IRA, your IRS-determined life expectancy, and then calculated based on an RMD, amortization, or annuitization method. You can choose the frequency of withdrawals, as long as they are at least once a year. You cannot customize the amount of your regular withdrawals, except by adjusting the total balance in your IRA account, using a rollover or funds transfer.
What are the advantages of using section 72(t)?
Section 72(t) has a few advantages for people who want to make early withdrawals from their IRA. The primary advantages are:
- Avoid the tax penalty. While withdrawals from a traditional, pre-tax IRA are still subject to income taxes, rule 72(t) allows you to avoid the additional 10% early withdrawal penalty.
- Schedule your withdrawals regularly. Using section 72(t), you can choose annual, quarterly, or monthly withdrawals from your IRA. This can help you plan and budget in the case of financial hardship and allows you to plan for your taxes.
What are the potential pitfalls of rule 72(t)?
For most investment advisors, early IRA withdrawals under section 72(t) are considered a “last resort”. Because there are other ways to manage a financial emergency, and even other ways to avoid the early withdrawal penalty, most financial advisors recommend protecting your retirement fund as long as possible, and not depleting it with SEPPs. Here are some of the disadvantages:
- Employer-funded plans are not eligible. If your IRA is funded with employer contributions, you are not able to schedule withdrawals under rule 72(t).
- You must adhere to the withdrawal schedule for the entire payment period. Setting up an SEPP requires you to take at least an annual withdrawal from your IRA, for a minimum of five years. If you miss one scheduled withdrawal, you owe the tax penalty on everything withdrawn up to that point. If you have a short-term financial crisis or emergency, this long-term withdrawal schedule may reduce your retirement investment more than necessary.
- Loss of some protections. If you are in a financial crisis or hardship, an IRA account has some protections from bankruptcy, creditors, and some legal judgments. The exact amount of protection varies by state, but keeping your money in your IRA is a good way to protect yourself in case of financial troubles and hardship. Once you withdraw the money from the IRA, it is no longer protected.
How Can IRAR Help?
IRA Resources Inc helps people grow their retirement accounts with lower fees and professional guidance. We offer free consultations on self-directed IRAs, alternative investments, and how to take advantage of these to reach your retirement goals.
If you are considering early withdrawals from your IRA, especially in the case of financial hardship or emergency, it’s important to consult with an accountant who can advise you on how to best access your retirement savings and account for the applicable taxes and penalties. Using Rule 72(t) is complex, and might be avoidable, so speak with your tax advisor before making any decisions.