The tax advantages available for saving in an IRA are intended to encourage saving for retirement. To discourage early use of IRA assets, an additional 10% tax applies to withdrawals taken before an IRA owner reaches age 59½. This “early distribution” tax applies to withdrawals that are otherwise taxable unless you meet an exception to the tax. One exception allows IRA owners to take a series of substantially equal periodic payments. These payments are also referred to as “72(t) payments,” named after the section of the tax code that sets the requirements for this payment arrangement. If you meet these requirements, you can access your IRA assets before age 59½ without paying the additional 10% federal tax.
To meet the 72(t) payment requirements, you must take at least annual payments from your IRA for at least 5 years and maybe longer if you have not yet reached 59½ once the 5 years have elapsed. The timing rule is the LONGER OF
• 5 years from the date of the first payment or,
• Until you reach age 59½
You cannot stop or alter the payments, and you cannot take any other distributions from the IRA. You also cannot put any more money into that IRA. If you don’t follow these rules, you will owe the 10% tax, plus interest, on all payments taken under the arrangement, payable in the year of modification. The only way payments can be stopped without retroactive application of the tax is if you become disabled or die, or the IRA is depleted by investment losses.
If Sheila begins a 72(t) payment arrangement at age 56, she will have to take payments for 5 years even though she turns 59½ in 3 years. Here are the dates of Sheila’s payments:
• Payment 1 = December 1, 2021 - age 56
• Payment 2 = December 1, 2022 - age 57
• Payment 3 = December 1, 2023 - age 58
• Payment 4 = December 1, 2024 - age 59
• Payment 5 = December 1, 2025 - age 60
Although Sheila’s 5th and final payment is made on December 1, 2025, she may not take a different distribution or modify her IRA until December 1, 2026, because the arrangement must last for at least 5 full years:
• 12/1/2021 - 12/1/2022 = year 1
• 12/1/2022 - 12/1/2023 = year 2
• 12/1/2023 - 12/1/2024 = year 3
• 12/1/2024 - 12/1/2025 = year 4
• 12/1/2025 - 12/1/2026 = year 5
Shawn turned 52 on February 1, 2021. If Shawn begins a 72(t) payment arrangement at age 52, he will have to take payments for 7 years until he reaches age 59½. Here are the dates of Shawn’s payments:
• Payment 1 = December 1, 2021 - age 52
• Payment 2 = December 1, 2022 - age 53
• Payment 3 = December 1, 2023 - age 54
• Payment 4 = December 1, 2024 - age 55
• Payment 5 = December 1, 2025 - age 56
• Payment 6 = December 1, 2025 - age 57
• Payment 7 = December 1, 2025 - age 58
• No payment due in 2028 because Shawn reached 59½ on August 1, 2028
Most 72(t) payment arrangements and annual distribution amounts are structured based on one of three IRS-approved calculation methods.
1. The RMD method calculates each year’s payment amount by dividing the prior year-end account balance by a life expectancy factor obtained from IRS life expectancy tables.
2. The amortization method calculates one set annual payment amount by amortizing the account balance over the IRA owner’s life expectancy using an acceptable interest rate.
3. The annuitization method calculates one set annual payment amount by annuitizing the account balance using an acceptable interest rate and an annuity factor.
The obvious benefit to taking 72(t) payments is avoiding the additional tax on IRA withdrawals taken before age 59½. This can be an important option if you are out of work for a period of time before age 60 but expect to resume working, or if you retire early and want to use your IRA assets to supplement or provide an income, particularly in the years before you qualify for your full Social Security retirement benefit.
The three approved calculation methods are generally intended to ensure that your IRA assets will not be depleted during the average life expectancy for your age. The annuitization and amortization methods can be helpful if you want to receive a consistent dollar amount each year. But they can result in a depletion of the account if the value of the investments drops significantly during the payment period. To address this potential after you have already started your payment arrangement, you may make a one-time switch from either of these methods to the RMD method. The RMD method allows your payment amount to fluctuate year to year to align with your investment gains and losses.
The opposite problem may also be a concern: you cannot take any additional money from your IRA once you start the 72(t) arrangement without triggering the retroactive tax. One strategy IRA owners use to avoid this situation is to split IRA assets into multiple IRAs and establish a series of payments from just one of the IRAs. The rules only prohibit you from taking additional withdrawals from the IRA making the 72(t) payment. So, the other IRA assets are available for distribution, without triggering the retroactive tax, if an emergency arises. By reserving a portion of your account balance in another IRA, you also preserve the option to add to that IRA through a rollover from an employer plan, for example, or by making annual IRA contributions if you are eligible.
If you’re considering taking 72(t) payments, work with a tax or financial provider to explore calculation options and the potential tax and savings impact.