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.
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 The payments must be withdrawn for a minimum of five years or until a person turns 59 1/2, whichever comes later.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.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
Haven't yet filed for Social Security? Create a personalized strategy to maximize your lifetime income from Social Security. Order Kiplinger’s Social Security Solutions today.
-
Visa Is the Worst Dow Stock Wednesday. Here's WhyVisa stock is down sharply Wednesday after the credit card company came up short of revenue expectations for its fiscal Q3.
-
Another Analyst Moves to the Sidelines on Tesla Stock After EarningsTesla stock is spiraling Wednesday after the EV maker's big earnings miss and Wall Street has been quick to weigh in. Here's what you need to know.
-
Medicare Basics: 11 Things You Need to KnowMedicare There's Medicare Part A, Part B, Part D, Medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare — and much more.
-
Six of the Worst Assets to Inheritinheritance Leaving these assets to your loved ones may be more trouble than it’s worth. Here's how to avoid adding to their grief after you're gone.
-
403(b) Contribution Limits for 2024retirement plans Teachers and nonprofit workers can contribute more to a 403(b) retirement plan in 2024 than they could in 2023.
-
SEP IRA Contribution Limits for 2024SEP IRA A good option for small business owners, SEP IRAs allow individual annual contributions of as much as $69,000 a year.
-
Roth IRA Contribution Limits for 2024Roth IRAs Roth IRA contribution limits have gone up for 2024. Here's what you need to know.
-
SIMPLE IRA Contribution Limits for 2024simple IRA The SIMPLE IRA contribution limit increased by $500 for 2024 and workers at small businesses can contribute up to $16,000 or $19,500 if 50 or over.
-
457 Contribution Limits for 2024retirement plans State and local government workers can contribute more to their 457 plans in 2024 than in 2023.
-
Roth 401(k) Contribution Limits for 2024retirement plans The Roth 401(k) contribution limit for 2024 is increasing, and workers who are 50 and older can save even more.
