Previous post:

Next post:

Should you use IRS rule 72(t) to access your retirement fund?

by retirebyforty on October 18, 2013 · 25 comments

in early retirement

Get free update via email:
RB40 won't spam you

Earlier this week, a stressed out reader asked if using IRS rule 72(t) to access his retirement fund is a good idea.  I knew you can use this rule to take distribution from your retirement accounts and avoid the IRS early withdrawal penalty, but I didn’t know all the details so I had to do some research. Usually, you will have to pay a 10% penalty if you withdraw from your retirement accounts before you’re 59½. The Roth IRA is a special case and we’ll discuss it later.

My early retirement plan is a bit different from traditional retirement. At 40, I’m not ready to stop working completely and just chill out all day. My early retirement will be funded by part time work and passive income streams. Here is a quick recap of my exit strategy.

  • up to age 40 – Work and build up net worth as much as we can and live a somewhat frugal lifestyle.
  • age 40 to 60’s – Explore part time self employment options and find other opportunities to generate some income. Mrs. RB40 will keep working for now. She is a workaholic and likes her job. Do not draw on retirement funds at this time. Putting off withdrawal is one of the keys to my exit strategy.
  • age 60’s to 100 – Both fully retire at some point and start to draw on our nest egg.

Leaving your retirement funds alone will give them a chance to compound. However, if you really need to call it quits today and haven’t set up any passive income streams yet, then your only choice might be to take distribution on your retirement accounts.

Disclaimer: If you’re planning to use rule 72(t), then please talk to a qualified tax accountant. Reading blogs and the IRS FAQs are clearly not enough for this important decision. If you don’t do it right, you might be assessed that 10% penalty.

early retirement withdrawal with rule 72t or Roth IRA

Rather be fishing?

How does rule 72(t) work?

Rule 72(t) will help you avoid that early withdrawal penalty, but you’ll have to follow some rules. First, you will have to take “substantially equal periodic payments” (SEPPs) every year. Once this starts, you must continue to do so for at least five full years, or if later, until age 59 ½.

If our 50 year old reader uses rule 72(t) then he will have to keep taking distribution from his retirement account until he is 59 ½. If he stops taking distribution early, then he will have to deal with our friends at the IRS.

How much can you take out?

I’m going to cheat here and tell you to Google “72t calculator.” There are 3 methods to calculate the distribution.

  • Required Minimum Distribution Method (RMD)
  • Amortization Method
  • Annuitization Method

Let’s try it out. We’ll assume a $1 million dollar portfolio and use the single life expectancy table. Here is what the calculator return.

  • RMD: $29,240/year
  • Amortization: $37,353
  • Annuitization: $37,178

At 60, we would have made 11 withdrawals and the balance is forecasted to be around $730,618 using the Amortization method.

Is 72(t)a good idea?

I don’t think this is a good idea unless you have a ton of money in your retirement account. You’d probably need at least a million bucks in your IRA to do this. Living on $37,000/year is doable if you don’t have any debt and your lifestyle isn’t extravagant. Your retirement account would shrink quite a bit by the time you reach 60 and you’d have to continue living on about $37,000/year. Social security benefits might help out though when you become eligible.

On the other hand, if you leave the retirement account alone, it could double in 10 years. With 2 million dollars, it would be possible to live a much more comfortable lifestyle when you really need it the most. Your time in retirement will be less and your nest egg bigger. That’s why I think it’s better to hold off on withdrawal.

Alternative – Roth IRA

Another way to access your retirement fund is through the Roth IRA conversion. You can build a Roth IRA ladder and withdraw without having to pay the 10% penalty.

  1. Roll over 401k to IRA
  2. Convert 1 year of living expense to Roth IRA. (You will have to pay tax when you do this.)
  3. Wait 5 years
  4. Withdraw 1 year of expense from the Roth IRA

Just repeat this every year until you’re 59 ½.

The drawback here is you have to wait 5 years before you can take out the first year of expense. If you already have a good-sized Roth IRA, then perhaps you can stretch it over the first 5 years. For example, your Roth IRA is worth $150,000. Let’s say your contribution is $100,000 and the profit is $50,000. You can withdraw $20,000/year for 5 years without having to pay any penalties.  With the Roth IRA, you can withdraw your regular contribution at anytime without having to pay the penalty. Conversions will have to wait 5 years to avoid the penalty.

You’d probably have to work a little bit or sell off some assets to make ends meet for the first 5 years, but after that, the Roth IRA ladder will kick in.

Probably better to hold off withdrawal

I think using the 72(t) rule is a bad idea unless you have absolutely no other choices. You’re locked into making withdrawals for at least 5 years. This is substantial and will deplete your retirement account which is meant to provide a comfortable lifestyle when you are older. From my point of view, it’s better to work a bit more while you can. If the job is too stressful, look for other less stressful or more rewarding ways to make money. On the other hand, if you have way more money than you’ll ever need in your IRA, then I’m sure it’s fine to use some of it early.

Good luck to every early retiree out there.

 

photo credit: flickr xibber

Get free update via email:
Stay in touch with Joe and see how he handles Retiring by 40 and being a stay at home dad.
We hate spam just as much as you

{ 25 comments… read them below or add one }

Fast Weekly October 18, 2013 at 3:38 am

I’m with you Joe. That all seems like a lot of hassle, and pretty risky going forward. However, if you have no choice…… I am going for several streams of income as well as diversifying my tax treatment (taxable, roth, and rollover 401k). That way I can use my taxable money first, then withdraw Roth contributions, then finally Roth earnings and the Rollover IRA. This made the most sense for me as I’m on track to retire early. Plus, who knows when the bureaucrats in Washington will change the rules.

-Bryan

Reply

retirebyforty October 18, 2013 at 2:06 pm

That’s why I like working part time if you want to retire early. It can make a huge difference in the long run.
For us, we’ll probably use a mix of withdrawal to minimize tax impact.

Reply

insourcelife October 18, 2013 at 7:49 am

I looked into this rule as well and it’s not for me… I don’t like anything that locks you into something you can’t control.

Reply

Art October 18, 2013 at 8:12 am

You should mention that you have to pay taxes when you convert to a Roth.

Reply

retirebyforty October 18, 2013 at 2:08 pm

Thanks for the reminded. I just added it to the article.

Reply

Done by Forty October 18, 2013 at 9:33 am

I like the Roth ladder quite a bit, because it allows you flexibility to take out amounts in a way that minimizes taxes. Depending on your situation, you may be able to take out money in amounts small enough to never pay significant taxes on your 401k funds.

We’ll be doing some version of this during early retirement (or at least that’s the plan!).

I agree on 72(t) though and we won’t be utilizing that plan. I hate the fact that the plan is inflexible, and once it’s set in motion it’s on autopilot for the next few years or decades.

Reply

retirebyforty October 18, 2013 at 2:11 pm

We’ll work on the Roth IRA ladder once Mrs. RB40 gets closer to retirement. She’s 12 years out now so there is no point yet.

Reply

Steve October 18, 2013 at 4:23 pm

I can’t disagree that it’s a risk to start these withdrawals with no way to stop them until the clock runs out. However, I can’t agree that you should avoid them just because you’re tapping your retirement resources. If you’ve saved for early retirement, at age 50 per the example, you *are* retired and it’s ok to use the money you’ve saved for that purpose. To access dividends, the dividend paying stocks have to be outside retirement accounts, in which case you are not getting the advantage of tax deferral.

Reply

krantcents October 18, 2013 at 4:50 pm

I think it is a tough call ! If you retire early and withdraw, you better make sure you have enough to last the rest of your life. The real growth in your retirement savings is in the later years.

Reply

jameswvu October 18, 2013 at 7:54 pm

From the 72t genius
Lets say you have 500k in IRA
1. Open another IRA
2. Move 100k to new IRA
3. Then setup SEPP.
4. This way only the 100k is obligated to follow 72T.
5. This give you flexibility in case you didn’t want to subject the whole 500k to IRS rules.

Reply

Kay October 28, 2013 at 3:58 pm

Can someone comment on this? This looks/sounds viable – allows access to IRA without damaging your TOTAL IRA funds.

Reply

retirebyforty October 28, 2013 at 11:32 pm

It sounds pretty good, but I have never heard of this. Probably have to check with a tax professional to make sure it’s OK.

Reply

steve October 19, 2013 at 12:56 pm

Here’s one good reason to start taking 72(t) withdrawals next year:

If you’ve done wise tax management and are retired early, you may not have enough taxable income to qualify for the subsidies in the affordable care act. If your 2014 income is under app. $16,000 you’ll be directed to the medicaid option, but some states have decided not to fund medicaid, so you’re buying insurance without qualifying for the subsidies. By doing 72(t) withdrawals you can bump up your taxable income enough to qualify for ACA subsidies.

Reply

retirebyforty October 20, 2013 at 9:56 pm

That’s interesting… I’ll keep that in mind. Thanks.

Reply

mary w October 19, 2013 at 4:26 pm

The closer you are to 59 1/2 the more it might make sense to make 72t withdrawals. At 40 it’s pretty dangerous since a lot of things could happen in the 20-25 years to normal retirement age. But if you’re 56 and suddenly unemployed, it may be your best option.

Reply

Bryce @ Save and Conquer October 20, 2013 at 10:24 am

I would hope anyone contemplating using 72(t) withdrawals has a large enough nest egg to pay expenses for the next 40 or 50 years. Don’t forget that the 4% inflation adjusted safe withdrawal rate (SWR) was only meant to last for 30 years. If someone is planning to live off retirement savings for a longer period of time, they will have to adjust the SWR downward, to something like 2.6 or 2.8 percent.

Reply

retirebyforty October 21, 2013 at 8:52 am

That’s why I think you need at least a million to even contemplate it. 2 million would be more comfortable.

Reply

Justin @ RootofGood October 20, 2013 at 1:42 pm

I plan on keeping the 72t option in my back pocket right now. Since I’m 33 and just retired, I’ll have 27 more years before I can modify the 72t withdrawals. I don’t want to lock myself in to 72t payments today. My plan is to run down my taxable account balances first, then possibly tap my 457. Depending on investment returns, this might get us 15-20 years into retirement. Jumping into a 72t withdrawal plan around age 50 (ie in 17 years) won’t be nearly as scary since it only locks in payments to me for 10 years.

For very early retirees ( below 40-45 years old), I would think hard about locking in withdrawals under a 72t. You never know if you’ll get bored or life circumstances might change, and you will want to return to work (for financial or non-financial reasons).

Reply

retirebyforty October 21, 2013 at 8:53 am

That’s a good plan. We probably won’t tap our retirement plan until we’re 60. However, if we have a huge retirement account by the time we’re 55, we might think about the 72t withdrawal.

Reply

mark October 31, 2013 at 8:30 am

if you are over 50 and have accumulated a lot of tax-deferred money, it may make sense to go with the 72T… it gives you an income stream till age 59 and it allows you draw down those accounts.. IRS makes you start drawing them down at age 70, See RMD… if you have a lot you could have a high tax bill..

Reply

retirebyforty October 31, 2013 at 11:05 pm

I was considering that too. Most people won’t have that problem though.

Reply

craig November 15, 2013 at 8:39 am

I thought there was a rule change after 50 if you sever service there is no penalty for accessing your 401 k plan as long as it stays and is not moved?

Reply

brkr12002 November 26, 2013 at 8:29 pm

I was going to throw this site out there for info on 72(t)
http://72t.net/
A couple of us on here are real deal into this stuff and are accountants, advisors, or actually doing reg 72(t) distributions.
The forums section has lots of good info, good examples of people doing it the right way; and probably more importantly, people who have majorly screwed up. Learn from their mistakes.

Reply

retirebyforty November 27, 2013 at 11:11 pm

Thanks for the info. I’ll head over and see what to avoid.

Reply

Ben November 15, 2014 at 8:44 pm

Using the rmd a $1,000,000 starting balance earring 5% would have a $1,170,000 balance at 60 years old. Using this method and assuming 5% earrings, the rmd would go up every year with the final year having a $48,000 rmd. A $1,170,000 balance earning 4% would give you $63,000+ a year for 25 years. Google rule 72t calculator and play with the numbers try best/worst case and somewhere in between. Do you want to enjoy your 50’s or hope your healthy enough or even alive in your in your late 80’s to spend all that money you’ve been saving. Does anyone really know what their life will be like at 85

Reply

Leave a Comment