FORVIS Private Client™ Quick Summary:
- Rule 72(t) allows for IRA distributions prior to age 59½ without a penalty
- Distributions are still taxed at ordinary income levels
- Once established, modifications are limited
There is a wide range of retirement strategies along with an increased interest in early retirement than in previous generations. Popular retirement strategies include individual retirement accounts (IRAs), employee stock ownership plans, 401(k)s, 403(b)s, 457s, and many more. Individuals have taken to heart the need to save for retirement, but what happens when retirement occurs before the IRS’ allowable retirement distribution age of 59½?
To discourage the use of retirement account assets before retirement, a 10% “early distribution penalty” generally applies on the pre-tax amounts distributed from a retirement account before the account owners reaches age 59½. However, Internal Revenue Code (IRC) Section 72(t)(2) provides a number of exceptions to this general penalty provision in certain circumstances. While many of the exceptions are somewhat narrow in their application, this article will focus on one exception that has broader potential applicability and garnered additional attention this year following the release of IRS Notice 2022-6.
Series of Substantially Equal Periodic Payments (SEPPs), i.e., IRC §72(t) Payments
An exception under IRC §72(t)(2)(iv) provides that the 10% early distribution penalty does not apply to distributions that are part of a series of SEPPs from an IRA. As with most exceptions to a rule in the IRC, there are a number of requirements that must be met to qualify. These requirements include:
- Payments must be made no less frequent than annually.
- The annual distribution must remain consistent until the individual reaches age 59½ or five years, whichever is longer.
- Once the SEPP distributions are in place, the 10% early distribution penalty applies retroactively to all pre-tax distributions taken prior to age 59½ if the payments are changed or canceled before the end of the five-year period unless an exception applies.
- Exceptions from this retroactive penalty include additional distributions for a major medical expense, first-time home purchase, higher education expense, disability, etc.
- No deposits are allowed into the account once SEPP distributions are in place.
- Distributions from pre-tax contributions to the account are taxed as ordinary income to the account owner in the year of receipt.
To calculate the amount of the IRC §72(t) payment, one of the following three methods established by the IRS can be used:
- Required Minimum Distribution – This method applies an appropriate life expectancy factor from the Uniform Lifetime Table, Joint and Last Survivor Table, or Single Life Expectancy Table and uses it to divide the IRA account balance. Keep in mind that the 2023 IRS life expectancy tables reflect an increasing life expectancy, which would produce a lower distribution amount than in prior years. Using this method produces the lowest annual withdraw amount and the annual payments are likely to vary from year to year.
- Annuitization – This method uses an annuity factor provided by the IRS to determine equivalent payments in accordance with the SEPP regulation. Using this method, the annual distribution amount tends to fall between the amortization amount and the required minimum distribution amount.
- Amortization – This method determines the yearly payment amounts by amortizing the balance of an IRA owner’s account over single or joint life expectancy and using a “reasonable” interest rate as discussed below. This method generally creates the largest amount an individual can remove, and the amount is fixed annually with no need to recalculate each year.
Under guidance issued in 2002, the interest rate that may be used for the purpose of SEPPs is any interest rate that is not more than 120% of the federal mid-term rate. However, last year, Notice 2022-6 updated the 2002 guidance by creating a 5% rate floor for purposes of the distribution calculations. Since applicable federal rates have only recently started to come up from historic lows, this new guidance allows account owners an option that produces a higher distribution rate—a change the taxpayer may find favorable.
The requirements and calculations are complex and require coordination with advice from both your tax and wealth management advisors. It is particularly important to consult your advisory team when selecting one of the three calculation methods discussed above to help avoid unnecessary modifications to your payments in the future and running the risk of all pre-tax distributions facing a retroactive 10% penalty.
Once your calculation method is decided, you will need to work with your tax specialist to make sure you account for the income taxes that will result from the distributions. Although these annual distributions may avoid the IRS early withdrawal penalty, they are still subject to federal and potentially state income tax, depending on the state where you live. These distributions are taxed federally at your ordinary income rate.
Using this strategy does come with risk. Most notably and discussed above, if the annual distributions are not consistent year over year, the IRS will consider the change a modification to the SEPP, resulting in a 10% penalty assessed on all previously distributed funds prior to age 59½. In addition, should the assets in the IRA account not perform well due to unfortunate market conditions, and the amortization method was used, you can experience a significant decline in account value.
Finally, the following are additional factors to consider when evaluating and implementing a strategy to use this exception to the early withdrawal penalty:
- If you have a large IRA balance, you may find benefit in splitting the balance between two IRA accounts prior to the start of SEPP distributions. This will allow access to a non-72(t) IRA account without triggering a modification to the 72(t) payments should an unfortunate event occur and you need these funds.
- The taxpayer is allowed one 72(t) election per IRA account. Should a taxpayer have multiple IRAs, the IRS does allow multiple 72(t) elections to be used across the various accounts.
- Most often we consider 72(t) distributions on traditional or rollover IRAs; however, as Roth IRAs have become more popular, it should be said that the IRC §72(t) payment exception also can be utilized from a Roth IRA account. A few points to this strategy include:
- A Roth IRA generally allows for the withdrawal of your original investment prior to age 59½ without increasing taxable income. Should earnings be taken out prior to age 59½, there is a 10% penalty plus tax due at your ordinary income rate.
- Using IRC §72(t) payments in this situation allows the owner to access Roth assets prior to age 59½ while avoiding the 10% penalty on the earnings.
Taking retirement account distributions prior to age 59½ is often seen as an off-limits option for many account owners. However, using the IRC §72(t) payment exception can be a helpful tool in managing cash flow in early retirement years. If you are considering early retirement and wonder if this strategy may be right for you, please reach out to a FORVIS Private Client professional or submit the Contact Us form below.