Early Retirement – IRS 72t – Avoiding the 10% Penalty

Two of the key questions we get asked at Wiser is, “When can I retire?” and “How much can I live on in retirement?”

Sometimes, the “When?” question doesn’t need to be asked.  Some fields have mandatory retirement ages.  Sometimes, health conditions may prevent you from continuing to work.  In some cases, you may be offered, or even forced into, early retirement from your place of employment.

The Social Security Administration defines full retirement age by year of birth.  Someone age 55 today, born in 1958, would need to work to a full retirement age of 66 years and 8 months, in order to receive full Social Security benefits.   The minimum age to receive benefits, at a reduced rate, is 62.

These ages are different from the IRS retirement age, which is 59 ½.  This is the age in which you can begin to take withdrawals from your retirement savings without incurring the 10% early withdrawal penalty.   So if you retire at age 60, you would need to have sufficient retirement investments to fund your expenses at a higher rate until you reach Social Security retirement age and can begin supplementing with those benefits.

What happens, though, if because of health or company early retirement mandates, you are forced to retire before age 59 ½?  How can you access your retirement savings without paying penalties? The answer is 72(t).

72(t) refers to a section of the IRS code that describes allowable exceptions to the 10% penalty tax.  One such exception is distributions received as a “series of substantially equal periodic payments.”

Payments must last for 5 years, or until you turn age 59 ½, whichever is longer.   The amount of the payments is determined by one of three methods:  the required minimum distribution method (same as for required distributions after you turn age 70 ½), the fixed amortization method, and the fixed annuitization method.  All three methods require use of a life expectancy table of which you have 3 choices – uniform life table, single life expectancy table, or joint life and last survivor table.

The amortization and annuitization methods require you to specify an acceptable interest rate.  You get to choose this rate, but it may not be more than 120% of the federal mid-term rate published in IRS revenue rulings for either of the two months preceeding the beginning of distributions.  These two methods result in a fixed payout that is the same each year.  The required minimum distribution method payout is recalculated each year.  The other two, as evidenced in their titles, are fixed to the same amount for the period of the 72(t).

Of the three methods the required minimum distribution method will give you the lowest amount, and the fixed annuitization method will give you the highest amount.   Using the single life expectancy table will give you a higher amount than the other two tables.

You are allowed to change the calculation method one time during the time period, but only from either the amortization method or the annuitization method to the required minimum distribution method.  Once you have made this change, you are required to use the new method for the rest of the time period.

Once you set up at 72(t), you are not allowed to alter it until after the 5-year/age 59 ½ period has passed.  If you do, say to take a lump sum out to pay an unexpected expense, or add additional money to the account, you will negate the exception and will be required to pay the penalty plus interest, backdated to the first withdrawal.  So it is important to have some separate emergency savings on hand for unexpected expenses. and to open new accounts for any new money.

If you have multiple IRAs, you are allowed to take 72(t) distributions on only one account.  You would then be able to save the other account(s) for emergency lump sum distributions (on which you would owe the penalty) or to create a second 72(t) distribution.  You are also allowed to aggregate the IRA amounts and pull the total 72(t) distribution from just one of the accounts.

There is no official IRS form for calculating the 72(t) distribution.  We recommend that you keep good documentation to support your calculation, in case the IRS asks for it.  This would include account statements, proof of the Federal mid-term rate used and its timing, and calculation notes.  Each year, when you do your taxes, you will receive 1099s on the distribution, and may be required to complete Form 5239.

So if you must retire before age 59 ½, take heart that you may be able to fund your first few retirement years without paying the 10% penalty.  Of course, if you cannot live on the amount allowed by the 72(t), and don’t have sufficient personal savings to make up the difference needed, you are still allowed to take out of the IRA what you need,  You would just pay the penalty on top of ordinary taxes.

 

 

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