IRAs are meant for retirement saving, and the IRS has put rules in place that limit your ability to tap these tax-favored retirement accounts early. Specifically, a 10% penalty usually applies if you try to withdraw money from an IRA before you turn age 59 1/2. However, there's an obscure exception to the penalty rules for early IRA withdrawals. It's known by its Internal Revenue Code section number, 72(t), and the Section 72(t) exception can be a useful tool to help you get early access to your retirement money without losing a big chunk of your money to the IRS in taxes and penalties. Yet it also comes with complications, and that's why many people hesitate before using the Section 72(t) exception in their own retirement planning.
The basics behind Section 72(t)
To be clear, Section 72(t) broadly sets forth numerous exceptions to the 10% penalty on early IRA withdrawals, with purposes including payments due to disability, certain medical expenses, or first-home purchases. However, what most people are talking about when they refer to Section 72(t) IRA early withdrawals is Section 72(t)(2)(A)(iv), so we'll call that provision the Section 72(t) exception throughout the rest of the article.
The general idea behind the Section 72(t) exception is that some people retire, either voluntarily or by force, before they reach age 59 1/2. For them, being able to get access to their tax-favored retirement accounts is crucial, and allowing penalty-free early withdrawals is a reasonable accommodation to their situations. For 401(k) plan withdrawals, separation from service is mandatory in order to claim the exception, but technically, IRA withdrawals under this provision are allowed even if you're still working.
The exception provides for distributions of substantially equal periodic payments. What that generally means is that you have to figure out an amount you can withdraw based on the IRA balance and your life expectancy. Once you start taking these payments, you have to continue taking them for five years or until you turn 59 1/2, whichever comes later.
What makes Section 72(t) so complicated
The main complication with Section 72(t) is that there are three different methods you can use to determine how much you can withdraw in payments. The life expectancy method is the simplest, using IRS tables to determine the appropriate factor for the calculation. For instance, say you have an IRA with $50,000 in it and the IRS table says that your life expectancy is 25 years. With the life expectancy method, your first-year withdrawal would be $50,000 divided by 25 or $2,000. In the following year, you take the new account balance and can either take your previous life expectancy and reduce it by one year, or look up the new life expectancy table figure based on your new age.
Alternatively, you can use more complicated methods that in some cases can lead to larger withdrawals. The amortization method allows you assume a certain rate of earnings that factors into the annual withdrawal amount permitted under the IRS tables, and that produces fixed year-to-year withdrawals. The annuity method doesn't use IRS tables at all, instead allowing the use of life insurance mortality tables to maximize potential withdrawals.
Resources like this online Section 72(t) calculator can help you with the necessary computations. For instance, running a calculation based on a $50,000 IRA for someone who is 55 years old, the life expectancy method provided for annual payments of about $1,700, with the amortization and annuity methods both coming in at close to $2,300.
Should you use the Section 72(t) exception?
As you can see from that example, the main challenge with the Section 72(t) exception is that it doesn't usually give most people the amount of money they need if they've truly retired early. For example, if you're in your early 50s, the IRS calculates your life expectancy as being 30 to 35 years, and that means you'll only be able to withdraw about 3% of your IRA balance each year under the exception.
Given the level of difficulty in figuring out payments, the long-term commitment to making withdrawals in future years, and the relatively small benefit, using the Section 72(t) exception is rarely worth the trouble. For certain unusual situations, however, the method can get you early IRA access in a way that will produce substantial tax savings.