The 72(t) rules, a series of substantially equal periodic payments, allow a person to tap retirement dollars before 59½ without a 10% early distribution penalty. However, to gain this early access, you must commit to a distribution plan according to strict guidelines in the Tax Code.
For example, some basic requirements dictate that:
- payments can begin from an IRA at any age, even if you are still working.
- distributions from a company retirement plan can begin if you are no longer an employee of that company.
- payments must continue for at least five years or until age 59½, whichever period is longer.
- The distribution must occur at least annually.
If you get sideways with the rules, a 10% penalty will apply retroactively to all distributions taken before age 59 ½, sometimes referred to as the “recapture penalty.”
To avoid this retroactive penalty, here is a handful of important “Don’ts” to consider:
- Don’t roll new money into the IRA account with the 72(t), and don’t make any contributions to that IRA. Both actions are a modification and will trigger the recapture penalty. Think of the IRA with the 72(t) as a fragile antique bowl filled to the rim with a volatile and explosive liquid. Those who start must carry this delicate bowl with them until the term expires. Handle it with extreme caution!
- Don’t withdraw more than what the payment structure allows. Sure, the IRS would get their taxes quicker if you took the larger distribution, but this is a deviation from the term and will be a modification.
- Don’t handcuff all your IRA money. If you can achieve your desired annual payout with a lower starting IRA value, it is highly recommended that you split the IRA. The strict rules (the “handcuffs”) will only apply to the IRA being annuitized. The IRA without the 72(t) can still be used for contributions, Roth conversions, rollovers, additional withdrawals, etc.
- Don’t alter the payment formula – stick to the script. Yes, there is a one-time change from the amortization and annuitization methods to the RMD method available, but be careful. Do not slosh the volatile liquid around too much in the antique bowl.
- Don’t stop the payments. Unless you die or become disabled, stopping the payments is a modification and will activate the recapture penalty.
- Don’t shortchange yourself with a low-interest rate. The IRS now permits the use of 5% for new calculations if applicable rates are lower. However, in a rising interest rate environment, it is imperative to be aware of current rates to maximize new schedules.
Don’t get loose with the rules. Carry that fragile bowl carefully. Do not spill a drop of the volatile liquid.
Any misstep or modification will trigger the recapture penalty!
By Andy Ives, CFP®, AIF®
IRA Analyst
