Early Withdrawal of Retirement Assets under Section 72(t)

The section 72(t) tax provision is like a socket wrench: You don’t need one often, but when you do, it’s the only tool that works. In this case, the job is helping a client tap a retirement account before age 59 ½.

A client who takes 72(t) distributions escapes the 10% early withdrawal penalty. The distributions — a series of substantially equal withdrawals based on their life expectancy — must be taken at least annually for five years or until the client reaches 59 ½, whichever takes longer. If the client deviates from the schedule, they are hit with retroactive penalties, plus interest, on all withdrawals.

The ideal candidate is a client in their early 50s with substantial retirement assets and no other significant savings, who wants to make a major career change or take advantage of a buyout package to retire early. The 72(t) provision doesn’t work well for young people, whose longer life expectancy shrinks the potential payments and lengthens the distribution schedule.

“We’ve set up 72(t)s for two clients who wanted the assurance of regular income while they established themselves in new careers. One was a consultant who became a novelist, and the other a corporate salesperson who went out on his own,” said Ross Levin, president of Accredited Investors Inc. in Edina, Minn. Although both men were successful, the 72(t) provision was a mixed blessing for the salesperson. “He built up a new income stream relatively quickly, and had to keep taking 72(t) distributions in a high tax bracket,” Mr. Levin said.

There are three safe harbors for determining the distributions:

Annual recalculation. Divide the client’s account balance by his life expectancy using the Single Life Expectancy table in IRS Publication 590. For example, a 50-year-old client has a 34.2-year life expectancy. If they have a $1 million individual retirement account, their first annual 72(t) distribution is $29,240.

Amortization. This method invariably yields a bigger payment. Using the same table, calculate equal payments that will last five years or until the client is 59½, whichever takes longer. You can assume the account earns 120% of the federal midterm rate for either of the two months before you start the 72(t) distributions, according to Barry W. Picker, a New York-based certified public accountant and certified financial planner.

“In September, that was 5.76%; in October, it was 5.23%. If you started a 72(t) schedule in November, you’d use the September rate. The higher the rate, the bigger the distribution,” he said. Assuming a $1 million IRA earns 5.76%, the 72(t) payment is $67,550 a year.

Annuitization. The method is the same as the amortization method, but using an insurance company mortality table instead of the IRS life expectancy table.

Can you switch from one calculation method to another after you start taking distributions? Yes. But only once, said Mr. Picker. If the market tanks, decimating the IRA’s value, for example, you can switch from amortization or annuitization to the recalculation method to avoid running out of money. (But you don’t have to do this to avoid a retroactive penalty; the IRS waives it if you blow the schedule because you ran out of money.)

For maximum flexibility, Mr. Picker recommended setting up a separate IRA to produce the 72(t) income. “If you later have a one-time need for more money, take it from another IRA. You’ll be hit for a 10% penalty, but only on that amount. It won’t be retroactive on all your 72(t) payments,” he said. “And if you have a recurring need for more money, you can start a new 72(t) schedule from another IRA.”

Make sure the client understands they can’t deviate from the payment schedule. “People sometimes assume they can withdraw extra money if it would qualify as a penalty-free withdrawal anyway,” said Mr. Picker. “Let’s say your 72(t) payment is $2,000 a month. One month you pull out an extra $10,000 to cover your kid’s college tuition. The tuition withdrawal is penalty-free but you’ve destroyed the 72(t),” he said. “You’ll owe a retroactive penalty on all your previous withdrawals.”

You can’t add money to an IRA that’s making 72(t) payments. The IRS is extremely strict about that, according to Mr. Picker. “There was a case where a taxpayer moved IRAs from one custodian to another, and in the course of the transfer, some non-72(t) assets got into the 72(t) account,” he said. “This happened just three months before the end of his five-year 72(t) schedule. He owed retroactive penalties and interest from day one,” Mr. Picker said.