Tag Archives: 72(t)

Accessing Retirement Accounts Prior to Age 59 ½

One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.

Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone).

My response: Oh, heck no!

Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.

The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.

Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options.

Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon.

Taxable Accounts

The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning.

Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!

But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy.

Spending taxable assets first tends to limit taxable income, which can open the door to (1) a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement.

There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion.

Cons: To my mind, there are few cons to this strategy in retirement.

The one con in the accumulation phase is that when we choose to invest in taxable accounts instead of in traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.

Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some.

Inherited Retirement Accounts

Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.

Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate.

Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth.

Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.

Rule of 55 Distributions

Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55.

This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty.

Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).

Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.

Limited availability as one must separate from service no sooner than the year they turn age 55.

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.

Governmental 457(b) Plans

Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉

Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date.

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.

Roth Basis

Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement.

Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½.

Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity.

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.

Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions.

Creates income for purposes of the FAFSA.

Ideal For: Those with significant previous contributions and conversions to Roth accounts.

72(t) Payments

I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.

Pros: Avoids the early withdrawal prior to turning age 59 ½.

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses.

Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.

There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges.

They are somewhat inflexible. That said, if properly done they can be either increased (by creating a second 72(t) payment plan) or decreased (via a one-time switch in method).

Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans.

HSA PUQME

Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s.

Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½.

Does not create income for purposes of the FAFSA.

Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.

Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.

We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity.

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.

Ideal For: Those with significant HSAs and significant PUQME.

Net Unrealized Appreciation

Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate.

This opportunity usually requires professional assistance, in my opinion.

The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock.

Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket.

Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly.

Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.

It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.

Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post.

Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan.

Pay the Penalty

The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.

Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops?

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done.

Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion.

Combining Methods to Access Funds Prior to Age 59 1/2

For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.

Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year.

Conclusion

Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Basketing for a 72(t) Payment Plan

Some retiring in their 50s will need to use a 72(t) payment plan. This often involves establishing a “72(t) IRA” and a “non-72(t) IRA.”

People wonder “how do you allocate your portfolio when you have a 72(t) payment plan?”

Below we tackle 72(t) IRAs from a tax basketing perspective. Most investors in the financial independence community want some allocation to bonds and some to equities.* Thus, questions emerge for those employing a 72(t) payment plan: what should be in my 72(t) IRA? What should be in my non-72(t) IRA?

* This post simply takes that as an assumption and is not investment advice for you or anyone else.

Watch me discuss portfolio allocation for 72(t) payments plans on YouTube.

72(t) Example

Monty, age 53, has a $2M traditional 401(k), $10,000 in a savings account, and a paid off house. He wants to retire and take his first annual $80,000 72(t) payment in February 2023. Monty also wants to have a 75/25 equity/bond allocation.

First, Monty would need to transfer his 401(k) to a traditional IRA (preferably through a direct trustee-to-trustee transfer).

Once the 401(k) is in the traditional IRA, Monty needs to split his traditional IRA into two traditional IRAs, one being the 72(t) IRA (out of which he takes the annual 72(t) payment) and one being the non-72(t) IRA.

To determine the size of the 72(t) IRA, Monty uses the commonly used fixed amortization method and decides to pick the following numbers:

Maximum allowable interest rate, 5.79%,
The Single Life Table factor for age 53 (33.4), and
The annual payment he’s selected, $80,000.

With those three numbers, Monty can do a calculation (see IRS Q&A 7 and my YouTube video on the calculation) and determine that the 72(t) IRA should be $1,170,848.59. Thus, the non-72(t) IRA should be $829,151.41.

72(t) Portfolio Allocation

How does Monty allocate the 72(t) IRA and the non-72(t) IRA such that (1) his overall financial asset portfolio ties out to the desired 75/25 allocation and (2) he is as tax optimized as possible.

I believe that Monty should aim to keep his 72(t) IRA as small as possible. Why? Because it is possible that Monty will not need his 72(t) payment at some point prior to turning age 59 ½.

Perhaps Monty inherits $300,000 when he is age 57. At that point, he can use that money to fund his lifestyle until age 59 ½. Why does he want to keep paying taxes on the $80,000 annual 72(t) payment?

Monty has an option available: a one-time change of the 72(t) payment to the RMD method. If Monty switches to the RMD method, he’s likely to dramatically reduce the annual amount of the required 72(t) payment. The RMD method keys off the account balance at the end of the prior year. The lower the balance, the lower the required annual payment under the RMD method.

Since Monty has decided to invest in equities and bonds, I believe that Monty should house his bonds inside his 72(t) IRA. While there are absolutely no guarantees when it comes to investment returns, equities tend to grow more than bonds. Since bonds tend to be lower growth, they are a great candidate for the 72(t) IRA.

It would stink if Monty wanted to reduce his annual 72(t) payment only to find that a 72(t) IRA composed entirely of equities had skyrocketed in value, increasing the amount of his revised annual payment under the RMD method.

Thus, I believe that Monty should put his entire bond allocation, $500,000, inside his 72(t) IRA. That makes the rest of the tax basketing easy: have the entire non 72(t) IRA be invested in equities, and have the remainder of his 72(t) IRA, $670,849, be invested in equities.

72(t), Sequence of Returns Risk, and Safe Withdrawal Rate

One must remember that 72(t) is entirely a tax concept. At least in theory, it has nothing to do with sequence of returns risk and safe withdrawal rate.

Some might look at the 72(t) IRA, $1,170,848.59, and say “Wait a minute: an $80K withdrawal is way more than 4% or 5% of that 72(t) IRA! Isn’t this a dangerous withdrawal rate? Doesn’t this amplify the sequence of returns risk?”

Remember, Monty’s withdrawal rate is $80,000 divided by the entire $2M portfolio (4%), not $80,000 divided by the $1,170,848.59 72(t) IRA. Further, Monty’s sequence of returns risk on this withdrawal rate exists regardless of the 72(t) plan. The greater the overall withdrawal rate, the greater the sequence of returns risk.

Lastly, the 5.79% interest rate Monty chooses has nothing to do with the withdrawal rate. It has everything to do with keeping the size of the 72(t) IRA as small as possible. The chosen interest rate doesn’t change the amount of the annual withdrawal ($80,000) but rather changes the size of the 72(t) IRA.

Conclusion

Tax basketing should be considered when crafting a 72(t) payment plan. I generally believe that investments that are less likely to have substantial gains sit better inside an investor’s 72(t) IRA rather than their non-72(t) IRA.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.

Retire on 72(t) Payments

Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?

This post is for you!

Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).

What to do, what to do? The tax law allows someone in this situation to take a “series of substantially equal periodic payments” to avoid the 10 percent penalty. The payments must occur annually for the longer of 5 years or until the taxpayer turns 59 ½.

72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.

Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) SEPP” or “SEPP”) and lay out what I hope will be an informative case study.

** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.

72(t) Substantially Equal Periodic Payments

Methods

The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.

The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.

We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).

Computing Fixed Amortization 72(t) Payments

To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.

Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.

Interest Rate: In a very positive development, the IRS and Treasury issued Notice 2022-6 early in 2022. This notice allows taxpayers to always use an interest rate anywhere from just above 0% to 5%. There is a second, older rule: the taxpayer can use any interest rate that is not more than 120% of the mid-term federal rate for either of the previous two months. The IRS publishes that rate on a monthly basis.

As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.

Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.

Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.

Size of the 72(t) IRA: This is what we’re solving for to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell.

Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.

Annual Equal 72(t) Fixed Amortization Payments

The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.

Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.

72(t) Payments Case Study

Let’s return to the example discussed above: it is early November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:

Interest Rate: 5.33% (the highest 120% of federal mid-term rate of the previous two months per the IRS)

Life Expectancy: 33.4

Payment: $80,000

The size of the 72(t) IRA is $1,236,012.95. See IRS FAQ Q&A 7.

Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,236,012.95 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.

Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.

Here’s what that looks like.

Interest Rate: 5.00%

Life Expectancy: 30.6

Payment: $10,000

The size of the second 72(t) IRA is $155,059.55.

Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on November 29th from the Second 72(t) in this hypothetical scenario.

Here is what Pat’s withdrawals would look like:

Year	Birthday Age	Required First 72(t) November 29 Withdrawal	Required Second 72(t) November 29 Withdrawal	Total Annual Withdrawal
2023	53	$80,000	$0	$80,000
2024	54	$80,000	$0	$80,000
2025	55	$80,000	$0	$80,000
2026	56	$80,000	$0	$80,000
2027	57	$80,000	$10,000	$90,000
2028	58	$80,000	$10,000	$90,000
2029	59	$80,000	$10,000	$90,000
2030	60	$0	$10,000	$10,000
2031	61	$0	$10,000	$10,000

Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.

Maintain Flexibility

I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?

First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.

Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.

72(t) Payment Plan Disqualification

A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.

A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.

There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.

72(t) Payment Reduction

Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2027 and thus no longer needs to take an $80,000 annual payment and pay tax on it.

Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.

But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2027 72(t) payment of $24,038.46.

If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2027 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.

The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.

72(t) Locking The Cage

The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.

Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!

Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.

Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).

Practice Point: Never add money to a 72(t) IRA during the lockup period. This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA.

IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest.

As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.

A Note on the 72(t) Risk Profile

The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.

Why?

Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.

Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.

72(t) Payment Tax Return Reporting

Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.

72(t) Is An Exception to More Than One Rule

72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.

Other Penalty Free Sources of Early Retirement Funding

Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.

Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:

Taxable Accounts: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.

Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.

Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.

Roth Basis: Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason.

I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).

72(t) Landscape Change

It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.

I Tweeted some additional thoughts on what the changing landscape means for how we should approach 72(t) payments.

72(t) and Employer Stock

What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).

I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.

Resource

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.

72(t) Series of Substantially Equal Periodic Payments Update

The IRS and Treasury have recently issued two updates to the rules for payments which avoid the 10 percent early withdrawal penalty from retirement accounts. These payments are referred to as a series of substantially equal periodic payments, SEPP, or 72(t) payments. This post discusses the updated rules.

72(t) Payments

Tax advantaged retirement accounts are fantastic. Who doesn’t love 401(k)s, IRAs, Roth IRAs, and the like?

However, investing through a tax advantaged account can have drawbacks. One big drawback is that taxable amounts withdrawn from a tax advantaged retirement account prior to the account owner turning age 59 ½ are generally subject to a 10 percent early withdrawal penalty. My home state of California adds a 2.5 percent early withdrawal penalty.

There are some exceptions to this penalty. One of them is taking 72(t) payments. The idea is that if the taxpayer takes a “series of substantially equal periodic payments” they can avoid the penalty.

72(t) payments must be taken annually. Further, they must last for the longer of (a) 5 years or (b) the time until the taxpayer turns age 59 ½. This creates years of locked-in taxable income.

There are three methods that can be used to compute the amount of the annual 72(t) payments. These methods compute an annual distribution amount generally keyed off three numbers: the balance in the relevant retirement account, the interest rate, and the table factor provided by the IRS. The factor is greater the younger the account owner is. The greater the factor, the less the account owner can withdraw from a retirement account in a 72(t) payment.

New 72(t) Payment Interest Rates

In January 2022, the IRS and Treasury issued Notice 2022-6. Hat tip to Ed Zollars for the alert. This notice provides some new 72(t) rules. The biggest, and most welcome, change is a new rule for determining the interest rate.

Previously, the rule had been that 72(t) payments were keyed off 120 percent of the mid-term applicable federal rate (“AFR”). The IRS publishes this rate every month. In recent years, that has been somewhat problematic, as interest rates have been historically low. For example, in September 2020, the mid-term AFR was just 0.42 percent. This made relying on a 72(t) payment somewhat perilous. How much juice can be squeezed from a large retirement account if the interest rate is just 0.42 percent?

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is just 0.42 percent:

120% of Sept 2020 MidTerm AFR		0.42%
Single Life Expectancy Years at Age 53		33.4
Account Balance		$1,000,000.00

Annual Payment		$32,151.93

Notice 2022-6 makes a very significant change. It now allows taxpayers to pick the greater of (i) up to 5 percent or (ii) up to 120 percent of mid-term AFR. That one change makes a 72(t) payment a much more attractive option, since periods of low interest rates do not as adversely affect the calculation.

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is 5 percent:

5% Interest Rate		5.00%
Single Life Expectancy Years at Age 53		33.4
Account Balance		$1,000,000.00

Annual Payment		$62,189.80

The new rule provides a 5 percent interest rate floor for those using the fixed amortization method and the fixed annuitization method to compute a 72(t) payment. Using a 5 percent interest rate under the fixed amortization method is generally going to produce a greater payment amount than using the required minimum distribution method for 72(t) payments.

The interest rate change provides taxpayers with much more flexibility with 72(t) payments, and a greater ability to extract more money penalty free prior to age 59 ½. Taxpayers already have the ability to “right-size” the traditional IRA out of which to take a 72(t) payment to help the numbers work out. In recent years, what has been much less flexible has been the interest rate. Under these new rules, taxpayers always have the ability to select anywhere from just above 0% to 5% regardless of what 120 percent of mid-term AFR is.

Watch me discuss the update to 72(t) payment interest rates.

New Tables

A second new development is that the IRS and Treasury have issued new life expectancy tables for required minimum distributions (“RMDs”) and 72(t) payments. Most of the new tables are found at Treasury Regulation Section 1.401(a)(9)-9, though one new table is found at the end of Notice 2022-6.

These tables reflect increasing life expectancies. As a result, they reduce the amount of RMDs, as the factors used to compute RMDs are greater as life expectancy increases.

From a 72(t) payment perspective, this development is a minor taxpayer unfavorable development. Long life expectancies in the tables means the tables slightly reduce the amount of juice that can be squeezed out of any particular retirement account.

This said, the downside to 72(t) payments coming from increasing life expectancy on the tables is more than overcome by the ability to always use an interest rate of up to 5 percent. These two developments in total are a great net win for taxpayers looking to use 72(t) payments during retirement.

Use of 72(t) Payments

Traditionally, I have viewed 72(t) payments as a life raft rather than as a desirable planning tool for those retiring prior to their 59 ½th birthday. Particularly for those in the FI community, my view has been that it is better to spend down taxable assets and even dip into Roth basis rather than employ a 72(t) payment plan.

These developments shift my view a bit. Yes, I still view 72(t) payments as a life raft. Now it is an upgraded life raft with a small flatscreen TV and mini-fridge. 😉

As a practical matter, some will get to retirement prior to age 59 ½ with little in taxable and Roth accounts, and the vast majority of their financial wealth in traditional retirement accounts. Notice 2022-6 just made their situation much better and much more flexible. Getting to retirement at a time of very low interest rates does not necessarily hamstring their retirement plans given that they will always have at least a 5 percent interest rate to use in calculating their 72(t) payments.

72(t) Payments and Roth IRAs

As Roth accounts grow in value, there will be at least some thought of marrying Roth IRAs with 72(t) payments.

At least initially, Roth IRAs have no need for 72(t) payments. Those retired prior to age 59 ½ can withdraw previous Roth contributions and Roth conversions aged at least 5 years at any time tax and penalty free for any reason. So off the bat, no particular issue, as nonqualified distributions will start-off as being tax and penalty free.

Only after all Roth contributions have been withdrawn are Roth conversions withdrawn, and they are withdrawn first-in, first-out. Only after all Roth conversions are withdrawn does a taxpayer withdraw Roth earnings.

For most, the odds of withdrawing (i) Roth conversions that are less than five years old, and then (ii) Roth earnings prior to age 59 ½ are slim. But, there could some who love Roths so much they largely or entirely eschew traditional retirement account contributions. One could imagine an early retiree with only Roth IRAs.

Being “Roth only” prior to age 59 ½ could present problems if contributions and conversions at least 5 years old have been fully depleted. Taxpayers left with withdrawing conversions less than 5 years old or earnings in a nonqualified distribution might opt to establish a 72(t) payment plan for their Roth IRA. Such a 72(t) payment plan could avoid the 10 percent penalty on the withdrawn amounts attributable insufficiently aged conversions or Roth earnings. Note, however, that Roth earnings withdrawn in a nonqualified distribution are subject to ordinary income tax, regardless of whether they are part of a 72(t) payment plan.

See Treasury Regulation Section 1.408A-6 Q&A 5 providing that Roth IRA distributions can be subject to both the 72(t) early withdrawal penalty and the exceptions to the 72(t) penalty. The exceptions include a 72(t) payment plan.

Additional Resource

Ed Zollars has an excellent post on the updated IRS rules for 72(t) payments here.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.