As American workers continue to leave their jobs in record numbers, the Series of Substantially Equal Payments provision, also known as Section 72(t), has moved to the forefront as an effective planning tool. Recent rule changes now make 72(t) even more attractive as a way for “early retirees” to bridge the income gap until their full retirement.[i] However, there are many rules involved with using 72(t), so it’s vital to become familiar with the tax implications of any missteps.
How Section 72(t) Works
Generally, if people need to tap their retirement accounts before age 59 ½, they will be subject to a 10% federal penalty tax on top of ordinary income tax for early withdrawals.[i] The IRS has established some exceptions to the penalty, including 72(t) payments. Section 72(t) permits penalty-free early withdrawals from a retirement account if the payments are received as a series of substantially equal payments for a minimum of five years or until age 59 ½, whichever is greater. Payments are taxed as ordinary income in the year received.[ii]
New Rule Effective December 2021[i]
The rule change affects the three methods for calculating payments—annuitization, amortization, and required minimum distributions (RMDs).
Under the previous rule, the interest factor used to calculate payments for the annuitization and amortization methods was 120% of the Applicable Federal Mid-Term Rate (AFR), which produced a maximum interest rate of 1.57%. Under the new rule beginning in January 2022, the interest factor is the greater of 120% of AFR or 5%.
The increased percentage results in substantially higher maximum annual 72(t) payments. For example, a person aged 50 with a $1 million balance in their IRA would generate a little more than $38,000 annually. With the new 5% “floor” percentage, the maximum annual payment jumps to more than $61,000.
The third method for calculating 72(t) payments is RMD. Previously, taxpayers used the old life expectancy tables that dated back to 2002 to calculate payments. Through the end of 2022, taxpayers can now use either the old tables or the new life expectancy tables that went into effect in 2020. Since life expectancy has grown since 2002, payments under the RMD method will be smaller because the account balance will be divided by more years. However, starting in 2023, the new tables must be used regardless of when the payments commenced.
Payment Schedule Must be Followed Strictly
Once a calculation method is used, you must stick to the payment schedule of the longer of five years or age 59 ½ even if you decide you don’t need them at some point. Stopping payments early will result in a 10% penalty on all payments received.[i]
The danger for some people is that they are committing to a strategy that may deplete their retirement savings too early. Just because you may be able to withdraw $60,000 a year doesn’t mean you should (there’s only a maximum limit, no minimum limit).
How to Reduce Retirement Account Depletion
If you decide to rejoin the workforce and start earning an income, you still have to complete your payment schedule. That could be more than just an inconvenience when you need to ensure your retirement account can generate lifetime income sufficiency. One way to avoid unnecessarily accessing funds you may not need is to transfer “excess” funds to another retirement account and keep only a balance that will generate the income you may need for that period of time.
For example, if you have $1 million in an IRA but determine you only need $300,000 to generate the income, you’re going to need for five years, you can transfer $700,000 to a rollover IRA. The smaller account balance will produce just the income you need allowing the rollover balance to keep growing.
Alternatively, if you start your payment schedule using the annuitization or amortization calculation method and want to reduce the required income payment, you can make a one-time switch to the RMD method.[i] You cannot switch between annuitization and amortization or from RMD to either of the other two methods, but you are allowed a one-time switch to the RMD method.
Utilizing 72(t) to fill an income void, while handy, should only be considered after other cash flow options have been exhausted. The closer you are to retirement, the more difficult it is to replace those early withdrawals. It would be critically important to meet with your financial advisor to consider your options and adjust your retirement planning to account for any retirement account depletion.
At URS Advisory, our chief concern is making sure our clients are able to live a comfortable and fulfilling retirement, regardless of when they need to access their money. This is just one of the many strategies we use to reach that goal. If you are interested in learning more about how we work with retirees and pre-retirees in the Palm Beaches and on the Treasure Coast, schedule a complimentary conversation with us today.
Advisory services are offered through URS Advisory LLC dba URS Advisory, an Investment Advisor in the State of Florida (CRD# 289892). Insurance products and services are offered through JEL Enterprises, Inc. dba URS Insurance, an affiliated company.
All content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. URS Advisory does not offer tax planning or legal services but may provide references to tax services or legal providers. URS Advisory may also work with your attorney or independent tax or legal counsel. Please consult a qualified professional for assistance with these matters.