The 72t Distribution Rule: How To Access Your IRA Money Early

Recently on my radio show Money Matters, I received an excellent question from a caller named “Steve.” He’s 52-years-old and worked for a company for 25 years before a restructuring led to his early retirement.

Steve’s personal roadmap for retirement had him stepping out of his career around age 60. He will likely be able to find another job, even if it doesn’t pay quite as much as his current position. Still, Steve is faced with a dilemma; he needs money to live on now.

So, how can Steve access his $1.3 million retirement savings today without penalty? What are the short and long-term implications of dipping into his IRA now? And, can he stop distributions when he gets another job?

Let’s get into the nuts and bolts of this one. It all centers on the 72(t) Rule.

The 72(t) Distribution Rule is an obscure Internal Revenue Service (IRS) regulation regarding the criteria for penalty-free, early withdrawal from an individual retirement account. Its name is derived from the section of the IRS code in which it is found.

Typically, there is a 10% penalty taken out of any early withdrawal from a retirement account, “early” meaning at any time before you reach 59 ½ years old. (This is on top of the income tax the IRS levies!) But if you follow the letter of the 72(t) regulation, you can avoid the penalty.

This brings us to our next question: How does the 72(t) Distribution Rule work? As it’s written, this exception from the IRS code provides that if you make a series of “substantially equal periodic withdrawals” (SEPPs) from the IRA, you won’t be subject to the 10% penalty, even if you are under age 59 ½. The withdrawals must be made at least annually (but can be taken more frequently, like monthly.

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There are three IRS-approved methods to choose from to determine your SEPPs, and all depend on a calculation of your life expectancy:

1. The Life Expectancy Method (Uses the minimum distribution rules)

2. The Amortization Method (Uses your life expectancy and a reasonable interest rate determined by the IRS)

3. The Annuitization Method (Takes your account balance and divides it by an annuity factor. The annuity factor is determined using your life expectancy plus an interest rate)

Once you do make your election, you have to keep taking the distributions, either over the span of five years or until you reach 59½, whichever time period is longer.

For example, if you start taking distributions under the 72(t) Rule when you are age 40, you’ll have to keep taking the payments until you reach 59 ½ – for 19 ½ years. But if you start when you are age 58, you only have to keep taking those payments until you reach age 63 – five years later.

Let’s consider a scenario when using the 72(t) Rule is probably not in your best interest.

Say, for instance, you’re in your early 50’s. Using the 72(t) Rule would force you to take distributions for almost a decade – until age 59 ½ – at which point your retirement nest egg will have been significantly depleted.

To use real numbers, if you are forced to take between 3% and 4% each year, you could have withdrawn 30% of your retirement money before age 60. Because folks are living well into their 80’s and even 90’s these days, you could be looking at another three or so decades of retirement. Entering your golden years with a siphoned retirement nest egg could significantly impact your financial health during your retired years.

Now let’s consider a situation where using the 72(t) Rule could be the best choice.

Imagine you need to access your IRA money maybe just a year or two early. Couple this with the fact that you are planning to use your IRA money in early retirement anyway. If you’re around 58-years-old, and you need to bridge the gap until you hit 59 ½, using the 72(t) Rule makes quite a bit of sense. Even if we consider that you’d take distributions of between 3% and 4% each year, tapping it 12 to 18 months earlier than you would have won’t put that much of a dent in your savings. Here, it’s a more prudent decision.

If you’re interested in how the 72(t) Rule would play out for you, take a look at this online calculator from Bankrate.com to see the impact it would have on your financial life during retirement.

My answer to Steve.

Back to Steve, my advice was that if he can avoid taking the distributions, it’s in his best interests financially. Were Steve to use the 72(t) Rule now, he’d have to take distributions for 7 ½ years. While that’s not as dire as our example above of taking early distributions for a decade, it’s still a pretty long time. But, with his $1.3 million nest egg, perhaps he can take the ding and not feel a burn when he gets to full retirement. The devil is in the details, and your individual circumstances are what will guide you towards your particular decision.

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