Having some talks with Papa Boomer about early retirement, I learned that he implemented a strategy called “72(t)” distributions. I just assumed that meant that he was having a midlife crisis and was going to by that 72 Thunderbird that he always wanted. Then I learned that this is a early retirement strategy that many implement to get access to their retirement funds before the age of 60. After some research, this is what I found out….
So what is 72(t) you ask?
Typically, if you withdraw monies out of your retirement plan before you reach the age of 59 ½, you are assessed a 10% penalty on the top of ordinary income tax. One exception (others include: first-time home purchase, college tuition payments, disability) to that is a 72(t) distribution that is a “substantially equal periodic payments”.
How Does the IRS Consider 72(t)?
Let me explain further. To determine your “substantially equal periodic payments”, you must use one of the three methods that the IRS has determined and then take your payment on a set schedule for a specific time period. It is required that you take those payments for either 5 years or when you turn 59 1/2 , whichever comes later. For example, if you start taking your payments at the age of 52, then you must do so for 8 years. Someone who starts at 57, must do so till the age of 62.
Determining if 72(t) is right for you.
If you start the 72(t) distributions and then decide later to stop them before the period is expired, you are assessed a very hefty penalty. You will be taxes the 10% penalty plus interest for every payment that you received. So for the 52 year old that decides at 58 to stop, they will go back 6 years and assess the penalty. What will also trigger the penalty if you are forced to take an additional payment from your retirement plan. So if you start the equal periodic payment and then a financial emergency that does not meet one of the exceptions arises and you are forced to take more money out, you will pay the penalty. This can be a very tax efficient planning strategy when used correctly.
Jeff Rose over at Good Financial Cents has some alternatives that one can explore if 72(t) does not work for you. I would definitely advise talking with a financial planner before implementing this strategy.