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.
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.
- Roll over 401k to IRA
- Convert 1 year of living expense to Roth IRA. (You will have to pay tax when you do this.)
- Wait 5 years
- 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.
This article is quite US centric. The rules are different in every country. If you are curious about how things work in Australia, you can read up on retirement on Suncorp’s website.
photo credit: flickr xibber