Tap Your IRA Early Without a Penalty

Saving for Retirement

Tap Your IRA Early Without a Penalty

Uncle Sam gives you a pass on the early-withdrawal penalty if you follow these complex rules.

EDITOR'S NOTE: This article was originally published in the December 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

Taking money from a traditional IRA early is rarely a good idea. It's best to allow the assets to grow tax-deferred. What's more, if you're younger than 59 1/2, you'll pay a 10% early-withdrawal tax penalty. But if you really need the cash—say, you're suddenly unemployed—you can avoid the penalty if you follow a number of complex rules.

See Also: The IRS Cracks Down on IRA Mistakes

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The IRS allows younger account holders to escape the penalty if they agree to take out "substantially equal periodic payments," called SEPPs, from their IRAs. The payments must be withdrawn for a minimum of five years or until a person turns 59 1/2, whichever comes later. For example, a 50-year-old has to take payments for at least nine and a half years, while a 58-year-old has to take payments until at least 63.


The "72(t)" strategy, named for the section of the tax code that sets out exceptions to the early-withdrawal penalty, should be a last resort. Once you start taking distributions, you're locked in. You can't make new contributions to the IRA or take additional withdrawals. If you violate any of the rules, you could pay big penalties. "The biggest disadvantage of 72(t) is inflexibility," says Mike Piershale, a financial adviser in Crystal Lake, Ill. As with typical withdrawals from a traditional IRA, distributions will be taxed at your ordinary-income tax rate.

The strategy could be useful if you need to supplement your income stream. Kimberly Foss, president of Empyrion Wealth Management, in Roseville, Cal., says a client used these payouts to bridge an income gap. He retired early at 55, but his pension didn't kick in until age 60.

Withdrawing the Money

The IRS provides three methods to calculate 72(t) payments. The annuitization and amortization methods are similar—you must take out the same amount every year. Payments from the distribution method may vary each year and tend to be smaller. Before choosing a method, says Denise Appleby, of Appleby Retirement Consulting, in Grayson, Ga., "run calculations through all three methods and see what matches the amount you need."

Let's say you choose the amortization method, which often provides the highest payout. With this method, the balance of your IRA is amortized over your life expectancy, based on IRS lifespan tables. The IRS limits the withdrawal size by using an interest rate that assumes that earnings won't grow faster than 120% of the midterm applicable federal rate. However, you can choose the best rate from the two months before the month you start payouts. For example, if you started 72(t) payouts in December, you could have used October's rate of 1.12%, instead of November's 1.07% rate.


You can figure out the annual payouts by using the calculator at 72t on the Net (www.72t.net). With the amortization method, a 50-year-old with a $400,000 IRA who uses an interest rate of 1.12% would take a $14,143 payout each year.

The IRS allows a one-time switch from amortization or annuitization to the distribution method. Say you are taking $5,000 a year from a $140,000 IRA. If a market downturn slashes the balance, you could decide to switch to the distribution method's smaller payout.

If the projected payouts are more than you need because your account balance is large, do a reverse calculation. Decide how much money you want each year, and then calculate the size of the IRA that provides that payout. You can split that amount into a second IRA, and take the 72(t) payouts from that account.

Before committing to at least five years of payments, consider other income sources first. Perhaps you can tap a home equity line of credit. Or maybe you're eligible for an exception to the early-withdrawal penalty—say, if you have a disability or high medical expenses. Also, if you leave your job in the year you turn 55 or later, you can take money from your company 401(k) without paying a 10% early-withdrawal penalty.


To set up 72(t) payments, notify your custodian. At tax time, make sure the 1099-R you receive has "Code 2" in Box 7, which tells the IRS the distribution is taxable but not subject to the penalty.

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