72(t) Rule: Definition, Calculation, and Example

Rule of 72(t) Rule of 72(t)

What Is Rule 72(t)?

Rule 72(t) allows for penalty-free withdrawals from individual retirement accounts (IRAs) and other tax-advantaged retirement accounts like 401(k)s and 403(b) plans. It is issued by the Internal Revenue Service (IRS).

This rule allows account holders to benefit from their retirement savings before retirement age through early withdrawals without the otherwise required 10% penalty. The IRS still subjects the withdrawals to the account holder’s normal income tax rate.

Key Takeaways

  • Rule 72(t) allows you to take penalty-free, early withdrawals from your IRA, 401(k), or 403(b).
  • There are other IRS exemptions that can be used for medical expenses, purchasing a home, and more.
  • Rule 72(t) withdrawals should be considered as a last resort when all other options for reducing financial pressure (creditor negotiation, debt consolidation, bankruptcy, etc.) have been exhausted.

Understanding Rule 72(t)

Rule 72(t) refers to code 72(t), section 2, which specifies exceptions to the early-withdrawal tax. These exceptions allow investors to withdraw funds from their retirement accounts before age 59½, as long as certain qualifications are met.

To take advantage of this rule, the owner of the retirement account must take at least five substantially equal periodic payments (SEPPs). The amount of the payments depends on the owner’s life expectancy as calculated through IRS-approved methods. You must also withdraw these funds according to a specific schedule. The IRS offers three different methods for calculating your specific withdrawal schedule. You must adhere to the payment schedule for five years or until you reach age 59 1/2, whichever comes later (unless you are disabled or die).

Calculation for Payment Amounts Under Rule 72(t)

The amounts an account holder receives in the periodic payments enabled by rule 72(t) depend on life expectancy, which can be calculated through one of three IRS-approved methods:

  • The amortization method
  • The minimum distribution or the life expectancy method
  • The annuitization method

The amortization method determines yearly payment amounts by amortizing the balance of an investor’s account over single or joint life expectancy. This method develops the largest and most reasonable amount an individual can remove, and the amount is fixed annually.

The minimum distribution method takes a dividing factor from the IRS’s single or joint life expectancy table, using it to divide the retirement account’s balance. The key difference between this method and the amortization method is the resulting payments with the minimum distribution method, as the name implies, are the lowest possible amounts that can be withdrawn.

The minimum distribution method is nearly the opposite of the amortization method, as the annual early withdrawal payments are likely to vary from year to year, though not substantially.

The final IRS-approved calculation is the annuitization method, which uses an annuity factor method provided by the IRS to determine equivalent or nearly equivalent payments in accordance with the SEPP regulation. This method offers account holders a fixed annual payout, with the amount typically falling somewhere between the highest and lowest amount the account owner can withdraw.

What Is the Downside of 72(t)?

Withdrawing money from a retirement account is a financial last resort. Using rule 72(t) will deplete your retirement savings, potentially putting the stability of your financial future in jeopardy.

Is 72(t) a Good Idea?

For many situations, using rule 72(t) is not a good idea. The risk to your future retirement may be too great to justify taking money out now. In some rare cases, however, it may be worth it.

What Is an Example of Withdrawing Money Early with Rule 72(t)?

As an example, assume a 53-year-old investor who has an IRA earning 1.5% annually with a balance of $250,000 wishes to withdraw money early under rule 72(t). Using the amortization method, they would receive approximately $10,042 in yearly payments. With the minimum distribution method, they would receive around $7,962 annually over a five-year period. Using the annuitization method, they would receive approximately $9,976 annually.

The Bottom Line

It's worth remembering that many retirement plans offer exceptions to the 10% penalty for certain circumstances, like disability and illness. If you do not meet any of the criteria for other exceptions, then rule 72(t) can be used if you have exhausted all other avenues. It should not be used as an emergency fund strategy, as any withdrawals could affect your future financial stability significantly.

Article Sources
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  1. Internal Revenue Service. "Substantially Equal Periodic Payments."

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