One of the chief disadvantages of individual retirement accounts (IRAs) and qualified plans such as 401(k)s is that you can't usually withdraw money from them before age 59-1/2 without paying a 10% early withdrawal penalty. There are circumstances in which an exception can be made -- for example, if you become disabled, buy your first home, or pay for higher education. However, you may want or need to withdraw funds for other reasons that don't qualify for one of these exceptions. For example, you may simply want to retire early and begin drawing down the income in your IRA for living expenses, or you may incur a debt or other expense that you need to pay off now and don't have other available funds to use.
Fortunately, there's a way for retirement savers to take at least a stream of income from their tax-deferred retirement accounts before age 59-1/2. IRS rule 72(t) allows for early withdrawals of "substantially equal periodic payments" (SEPPs). A SEPP is a certain amount of money you can withdraw from your IRA or qualified account each year. Note that qualified plan participants cannot start a SEPP program if they are still working for the employer that sponsors the plan.
However, this allowance comes with some big caveats and commitments that you should be aware of.
Once you start taking a SEPP, you must take the distribution annually; it cannot be postponed for more than a year. This distribution must also be taken for at least five years or until the account owner reaches age 59-1/2 -- whichever comes last.
For example, a 58-year-old who takes out a SEPP distribution must continue to do so until he or she reaches age 63. He or she cannot stop this distribution at age 59-1/2, because in this case, the five-year minimum has not been satisfied. Anyone who is 54 years old or younger must continue with their 72(t) payout until they are at least age 59-1/2. Once the longer of these two windows of time has been met, distributions can be stopped without penalty.
Many financial planners discourage their clients from taking this kind of distribution, because if it is altered in any way before the time or age limit is satisfied, then all distributions that have been taken under this rule will suddenly become taxable. For example, a client could elect to take this type of distribution and have it deposited into his or her savings account. If this person then switches to a different savings account at another bank and forgets to notify the IRS of the change in a timely fashion, then the next distribution that is paid into the closed account will kick back to the IRS, and the stream of payments will be interrupted. He or she will have to declare the entire amount of all previous distributions that were taken as an early withdrawal that is subject to the 10% penalty.
This can be a nasty surprise for a client who has this type of payment plan all worked out and then has it disrupted for any reason. Those who are forced to pay taxes and penalties on all of their prior SEPP distributions may end up in a higher tax bracket for the year and thus pay unnecessary taxes. However, an exception to this rule is made in the event of death, disability, or account depletion. For these reasons, most financial planners discourage their clients from taking SEPP distributions unless it is absolutely necessary.
Another key disadvantage that comes with taking SEPP distributions is that they disallow the owner from making any further contributions to their IRA while the plan is in effect. However, they can still contribute to another IRA or qualified plan while they take their SEPP.
Determining the amount of SEPPs
There are three separate methods that you can use to calculate your distribution amount each year.
- The amoritzation method: Under this method, the payout is calculated based on the life expectancy of the IRA or qualified plan owner and their beneficiary, if there is one. An assumed rate of interest is factored into the calculation, and an identical amount is paid out each year.
- The annuitization method: Like the amortization method, payments under this method will be the exact same amount each year and will use an assumed interest rate. This method calculates the payout using an annuity that is based on the participant's life expectancy (and that of their beneficiary if necessary). The annuity factor in the equation is drawn from the IRS mortality tables.
- The required minimum distribution method: This calculation will usually create a much smaller payout than the other two options. The amount that is paid under this method also changes each year, as it is calculated by dividing the current account balance by the participant's (and beneficiary's, if applicable) life expectancy factor each year. This has to be done each year, as the account balance can fluctuate, and life expectancies also change from year to year.
The IRA or retirement plan owner can also aggregate multiple accounts for the purpose of taking a larger distribution, and the aggregate payment can be drawn from only one of those accounts. However, they will not be allowed to contribute to any account upon which payments are calculated. For example, if someone has two IRAs and a 401(k) plan from a previous employer, and they use the aggregate account balances in all three accounts to calculate their payment, then they can take the entire payment from just one of those accounts, but they cannot make additional contributions into any of them. (Of course, they couldn't make further contributions into the 401(k) plan in any case, since they no longer work for that employer.) But they are not required to automatically aggregate all of their tax-deferred plans and accounts when they calculate their SEPPs; they may only use one of them if they so choose.
The rules also allow participants to make a one-time change from either of the first two methods listed above to the required minimum distribution method. This is because the IRS has found that account owners who use the amortization or annuitization method often deplete their retirement savings much faster than they had expected. So take that as a warning.
72(t) distributions can provide a handy way for you to begin drawing money from your retirement plans and accounts before age 59-1/2, but you'd better know what you are doing before you sign up. Be sure that you understand all of the applicable rules and follow them to a tee so you're not inadvertently hit with a substantial penalty. Some IRA and qualified plan owners who run afoul of these regulations end up setting themselves back a decade or more in their retirement planning, so don't be one of them. For more information on 72(t) distributions, visit the IRS website here or consult your tax or financial advisor.