Tapping into your retirement savings before age 59.5 typically triggers a 10% early withdrawal penalty in addition to the income taxes you’ll owe. Using Internal Revenue Service Rule 72(t) can help you generate income from your nest egg in your 50s or earlier without paying that penalty. If you use it, you’ll still have to pay regular income taxes, and the process is complicated and inflexible.
Talk to a financial advisor to get personalized guidance on your options for generating retirement income before 59.5.
Rule 72t Fundamentals
Rule 72(t) is a section of the tax code covering early withdrawals from retirement savings plans. This particular rule allows you to take substantially equal periodic payments (SEPPs) from an IRA, 401(k) or other qualified retirement plan without incurring the 10% early withdrawal penalty you would otherwise generally have to pay.
To employ Rule 72t strategy, you must take annual distributions calculated using one of three IRS-approved methods for determining the payment amount. These SEPPS must continue for five years or until you reach age 59.5 – whichever is longer.
You can’t adjust the payment amounts during this time or else you’ll face the penalty you initially avoided. You also can’t make additional withdrawals from the account beyond your scheduled payments. This inflexibility makes Rule 72(t) tricky to use. But for those with adequate savings who want to retire early, it can provide penalty-free income.
Understanding Substantially Equal Periodic Payments
The IRS has a specific interpretation of what constitutes a SEPP. The three methods allowed by the IRS for calculating SEPPs are:
- Required minimum distribution (RMD) method: This typically produces the smallest annual payment.
- Amortization method: This spreads your balance over life expectancy to produce a larger payment amount.
- Annuity method: This provides a fixed mid-range payment between the RMD and amortization methods.
You must calculate payments based on your life expectancy, so the older you are when starting them, the higher the amounts will be.
A Rule 72t Example
To get an idea of how Rule 72t might work in a hypothetical case, consider a retirement saver who is 55 and has $800,000 in their retirement accounts when they decide to retire early. Using the amortization method and a 5% assumed interest rate, they could take annual payments of $49,500 from their accounts for the next 10 years until they turn 65.
By doing this, they would avoid having to pay the 10% early withdrawal penalty, which would save $4,950 for each of the payments until they reach age 59.5.
Talk to a financial advisor about the best plan to finance your retirement.
Rule 72(t) Limitations
While Rule 72(t) offers a path to penalty-free retirement income before 59.5, there are some real and potential limitations to its benefits. They include:
- You still must pay income tax on distributions at your regular rate.
- Once started, you can’t discontinue payments without a penalty.
- Calculating your precise payment involves complex math.
- You lose tax-deferred growth by withdrawing the money.
- You can no longer contribute to the account after you start withdrawing from it.
Given these restrictions, Rule 72(t) works best for those who have adequately saved and are sure they want to begin retirement distributions in their 50s.
Rule 72(t) Alternatives
Rule 72t can provide a way to tap retirement funds penalty-free without having to wait, but it’s not the only approach. Other potential options include:
- 401(k) loans, allowing you to borrow from yourself and repay the money.
- Using the Rule of 55, which lets you tap a 401(k) penalty-free after leaving an employer at 55 or later.
- First-time homebuyer withdrawal, permitting a $10,000 penalty-free IRA withdrawal towards buying your first home.
- Certain other exceptions, such as for higher education costs and some medical expenses.
Each approach has pros and cons to weigh. Hardship withdrawals are still taxed as income but avoid the 10% penalty. 401(k) loans allow access without taxes or penalties but must be repaid. The Rule of 55 only applies to employer plans, not IRAs. A financial advisor can help you weigh your options and make a plan for a comfortable retirement.
Bottom Line
Rule 72(t) allows penalty-free early withdrawals from retirement accounts, but comes with major restrictions. While avoiding the 10% penalty, you still owe income taxes on distributions. Payments are fixed for 5+ years and can’t be changed without penalty. You lose tax-deferred growth and can’t contribute anymore. Given the limitations, Rule 72(t) only works for someone with adequate savings who is fully committed to early retirement.
- Have a financial advisor walk through the pros, cons and calculations involved with a Rule 72(t) distribution strategy. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s Retirement Calculator helps you determine whether you’re saving enough to retire.
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FAQs
Rule 72(t) allows penalty-free early withdrawals from retirement accounts, but comes with major restrictions. While avoiding the 10% penalty, you still owe income taxes on distributions. Payments are fixed for 5+ years and can't be changed without penalty. You lose tax-deferred growth and can't contribute anymore.
What is the rule 72 T to avoid withdrawal penalties? ›
If you have an IRA account then you can elect to withdraw funds via rule 72(t) if you take at least five substantially equal periodic payments (SEPPs). This rule allows individuals to make early, penalty-free withdrawals from their IRA, which are calculated using three IRS-approved methods.
How early can you start a 72t distribution? ›
You may begin at any age under 59 ½. However, you must set up a schedule of substantially equal payments (paid at least annually) that is calculated in accordance with IRS requirements and is based on your life or life expectancy (or the joint life or life expectancy of you and your beneficiary).
What are the exceptions to the early withdrawal penalty? ›
Despite these stringent withdrawal rules, there is a broad array of exceptions to the IRA early withdrawal penalty. These exceptions encompass a diverse range of circ*mstances, including higher education expenses, unreimbursed medical expenses, disability and first-time home purchases, among others.
Can I use my retirement money early? ›
You can withdraw money from your IRA at any time. However, a 10% additional tax generally applies if you withdraw IRA or retirement plan assets before you reach age 59½, unless you qualify for another exception to the tax.
What is the downside of 72t? ›
Depleting Retirement Savings Too Early. One of the primary risks associated with 72(t) distributions is the possibility of depleting retirement savings too early, which can jeopardize long-term financial security. It's essential to carefully consider the potential impact of early withdrawals on future retirement income ...
How do you qualify for 72t? ›
Client must take a series of substantially equal periodic payments (at least annually). Client must continue taking the distributions (even if they no longer need them) for at least five years or until they reach age 59½ whichever is longer.
Can you take 72t distributions from multiple accounts? ›
Separate your accounts first.
When you establish a 72(t) payment plan, the distributions can be calculated using the balances of one or more IRA accounts. But once the 72(t) schedule is in place, the rules significantly restrict your ability to make changes to the accounts without incurring penalties.
Can I use 72t to retire early? ›
Rule 72(t) allows penalty-free early withdrawals from retirement accounts, but comes with major restrictions. While avoiding the 10% penalty, you still owe income taxes on distributions. Payments are fixed for 5+ years and can't be changed without penalty. You lose tax-deferred growth and can't contribute anymore.
Which is better rule of 55 or 72t? ›
According to Birkett-Brunkhorst, the rule of 55 is more flexible than rule 72(t) as it allows you to determine when funds are withdrawn from your workplace plans.
Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. However, that doesn't mean there are no consequences. All withdrawals from your 401(k), even those taken after age 59½, are subject to ordinary income taxes.
Do you have to show proof of hardship withdrawal? ›
You do not have to prove hardship to take a withdrawal from your 401(k). That is, you are not required to provide your employer with documentation attesting to your hardship.
What is a hardship withdrawal? ›
A hardship withdrawal is an emergency removal of funds from a retirement plan, sought in response to what the IRS terms "an immediate and heavy financial need." This type of special distribution may be allowed without penalty from such plans as a traditional IRA or a 401k, provided the withdrawal meets certain criteria ...
At what age does RMD stop? ›
Required minimum distributions (RMDs) are the minimum amount that you must withdraw from certain tax-advantaged retirement accounts. They begin at age 72 or 73, depending on your circ*mstances and continue indefinitely. There is, unfortunately, no age when RMDs stop.
Can I close my IRA and take the money? ›
Generally, early withdrawal from an Individual Retirement Account (IRA) prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty. There are exceptions to the 10 percent penalty, such as using IRA funds to pay your medical insurance premium after a job loss.
Does credit card debt count as hardship withdrawal? ›
Paying off credit card debt doesn't fit the IRS hardship definition, but some plans do allow a hardship withdrawal for paying off debt. The only way to find out if yours permits it is to ask the plan administrator.
What is 72t and how does it work? ›
Rule 72(t) allows penalty-free early withdrawals from retirement accounts, but comes with major restrictions. While avoiding the 10% penalty, you still owe income taxes on distributions. Payments are fixed for 5+ years and can't be changed without penalty. You lose tax-deferred growth and can't contribute anymore.
How do I avoid early retirement withdrawal penalty? ›
Generally, the IRS will waive the early distribution tax penalty if these scenarios apply:
- You choose to receive “substantially equal periodic” payments. ...
- You leave your job. ...
- You have to divvy up a 401(k) in a divorce. ...
- You are a domestic abuse survivor. ...
- You are terminally ill.
- You become or are disabled.
It is issued by the Internal Revenue Service. This rule allows account holders to benefit from their retirement savings before retirement age through early withdrawal without the otherwise required 10% penalty. The IRS still subjects the withdrawals to the account holder's normal income tax rate.
How do I avoid withdrawal penalty? ›
The IRS allows penalty-free withdrawals from retirement accounts after age 59½ and requires withdrawals after age 72. (These are called required minimum distributions, or RMDs). There are some exceptions to these rules for 401(k) plans and other qualified plans.
