Rule 72(t). The name sounds as boring as 401(k). And it should because it’s from the same place – the Internal Revenue Code.
Both are part of the tax law that the IRS gets to govern.
Coincidentally, both Rule 72(t) and 401(k) plans are pertinent to this post.
I recently wrote a post about our FIRE plans titled The Roth IRA Conversion Ladder Dilemma. I talked about how we plan on using the ladder to access our tax-deferred accounts earlier than the traditional retirement age.
The problem we ran up against is covering the 5-year gap in the meantime until we can access the funds. We need to have enough money in our taxable accounts to make that happen… and we don’t.
My solution is to work another couple of years to make this happen. However, a couple readers suggested that Rule 72(t) might be a better solution, so I thought we’d talk more about that today.
What is Rule 72(t)?
Let’s start with a little bit of a description of what Rule 72(t) actually is.
Rule 72(t) is… well, a rule. It’s issued by the IRS and allows you to take money out of your IRA penalty-free.
Moreover, you can start this process at any age!
So, if you have a 401(k) or other similar plan and quit your job, you can roll your account into a traditional IRA.
Regardless, once the money’s in a traditional IRA, you’re permitted to withdraw equal payments from it at any point in time as long as you follow the guidelines of the rule.
You’ll be taxed on it obviously, though so you want to make sure to plan this out carefully.
Sweet!! So far, so good… what’s the catch?
So here’s what makes this rule fun. Once you start pulling money out of your IRA, you must continue to do this every year.
Still doesn’t sound too bad, right?
Well, here’s the fun… the rule is very specific. You must pull out substantially equal periodic payments (SEPPs) each year.
What the @#$% does that mean???
Whoa – easy… no need to get all riled up!
Substantially equal periodic payments (SEPPs) mean that once you start taking distributions, you have to keep pulling out the same or similar amount (depending on the method) each time. You can start these distributions at any time, but you need to continue making them every year for five years or until you turn 59½, whichever is a longer span of time.
You also don’t get to choose the amount of these payments. They’re based on one of three methods from the IRS that you select to use:
- Required minimum distribution (RMD) method – This method calls for you to divide your IRA account balance by your life expectancy to determine your payment. Your life expectancy number is taken from the IRS documentation. It took me a while to find this on the IRS site, but here’s the current document as of 2017. Let’s say you’re a 45-year-old individual (we’ll leave out joint accounts for now) ready to start this process. The documentation states that your life expectancy is 38.8 years. So if you had $1,000,000 in your IRA ready for Rule 72(t), your payment would be $1,000,000 / 38.8 = $25,773. With this method, you recalculate every year to determine your RMD.
- Fixed amortization method – For this method, you amortize your account balance over your life expectancy based off the same IRS documentation mentioned in the RMD method. The interest rate to use is not specifically declared by the IRS, but said to be a “reasonable interest rate” and not more than 120% of the federal mid-term rate. So, for our example, if we used the January 2017 federal mid-term rate of 2.36% over the same life expectancy of 38.8 years, the payment amount would be $39,632. This number is much higher than the RMD method, but it’s fixed and will be the annual amount you withdraw every year.
- Fixed annuity factor method – In this method, a different document is used from the IRS – the Appendix B mortality table from Rev. Rul. 2002-62. It uses the same reasonable interest rate I mentioned in the amortization method. The formula involves dividing your IRA balance by your age annuity factor (found in the mortality table). This is actually the most complex of the methods and, believe it or not, I can’t find something solid to explain how to calculate the annuity factor. The IRS states that you use an annuity factor that would provide one dollar per year over [your] life, beginning at [your current age]. That doesn’t help me. However, in our example, according to a distribution calculator, we would end up with $39,423. The distribution number is also a fixed amount and the same amount that you withdraw annually.
If this math gets a little confusing (especially the fixed annuity factor method!), here’s an easy calculator at Bankrate that’ll help you compare all three methods at once.
A Few Other Important Tidbits
- If you initially choose the amortization or annuity factor methods, you’re permitted a one-time switch to the RMD method.
- If you screw up on your distributions by missing or not pulling the right amount, you no longer get the 10% penalty exemption. Additionally, all the prior distributions you took before 59½ will be penalized as well… ouch!
- I kept it simple above by using the Single Life Expectancy table for the RMD and amortization method examples, but depending on your situation, you may want to look at the Uniform Lifetime table or the Joint Life and Last Survivor Expectancy table.
Rule 72(t) is a Real Control Freak!
As you can see, Rule 72(t) has some definite control issues. In fact, the amortization or annuity factor methods can leave you in a real pinch if you’re doing this over a large number of years.
Because the amount stays the same, your distribution won’t keep up with inflation. Maybe the initial dollar amount works for you now, but how much less will it feel in 10 or 15 years?
Only the RMD method has distributions that will vary each year. However, you don’t have any flexibility in that variation and you can’t control it… that could be a big problem.
In theory, your account balance could rise pretty dramatically if your investments run through a bull market over the year. That could then increase your RMD for the following year. Sounds pretty good, except that’s unlikely to happen every year.
If we go through a bear market, that can really affect your RMD in a negative way. Not having any control over that payment makes this a somewhat tougher pill to swallow.
However, it doesn’t mean that Rule 72(t) wouldn’t be a suitable fit you. It just means that you need to consider all points before using this as an escape hatch to early retirement.
Taking a Little Control Back
It seems like whenever there are restrictions, someone figures out a way to get around those restrictions.
In the case of Rule 72(t), someone got a little smart. The rule states that the distributions you take are applicable to the IRA(s) that you used to calculate your initial payment.
If you don’t want to get stuck locked into these distributions, you can do some planning before you move forward on this. You’re allowed to split up your IRA into multiple IRAs. And Rule 72(t) lets you specify which IRA (or IRAs) you want to pull from.
Therefore, you can divide it up so you have the desired amount in one IRA to withdraw from and the other IRA would then remain unaffected by this process. This gives you a little more control over your future.
Pretty cool, right?
Does This Change Our Plan?
If you remember from my post, we’re in good shape in the R2R household (financially, not mentally!). We’re very close to being financially independent with the assumption that we’re moving to Panama. With one exception.
Our money is not spread out in the right buckets. We don’t have enough money in our taxable accounts to cover us over the five-year waiting period that’s required if we go with a Roth IRA Conversion Ladder like we’re planning to do.
So, does Rule 72(t) change our plan?
Maybe, and I might still consider this as an option over the Roth IRA Conversion Ladder. However, I think I’m going to stick with the plan of continuing to work for another couple of years.
Not only will that give us more time to stack a bigger pot to draw from, but it’ll ensure we have multiple options – and we all love those!
In the meantime, that potential noose around my neck that Rule 72(t) is nice enough to provide is a little bit of a turnoff. Once you’re in, you’re committed. And things always change, so I want to be sure we can adapt as needed.
Sure, I don’t want to work any longer, but if it costs me two years of just sucking it up in order to have decades of enjoyment (assuming I don’t quit my job and keel over dead!), then it’s worth it. Small price to pay to be able to retire at 45.
What do you think makes more sense for my situation? Have you considered using either a Roth IRA Conversion Ladder or Rule 72(t) as part of your FIRE plan?
Thanks for reading!!