Taking IRA distributions early without penalty

We’ve all heard the common rule that you can’t access your IRA funds until age 59 ½ without incurring a 10% penalty. Less commonly known is a provision in the tax code that allows you to take distributions earlier, without any penalty. This provision has restrictions however, and is only suitable for certain individuals.

The provision is known as 72t, and the distributions are called 72t distributions. It’s named after Internal Revenue Code (IRC) Section 72, part t. The most popular part of this section allows individuals below age 59 ½ to take IRA distributions in a “series of substantially equal periodic payments”. The amount of the payments is calculated according to rigid formulas. The amounts must follow those formulas precisely, or else they are subject to penalty. Additionally, once you begin taking these distributions, you must continue them for at least five years or until you reach age 59 ½, whichever is longer.

There are three different formulas you can use to calculate the distribution amounts.

1. The Required Minimum Distribution method is the simplest, but usually results in the lowest payment. The RMD method divides your current balance by your single life expectancy, or joint life expectancy with your oldest beneficiary, using life expectancy tables published by the IRS.

The payment amount is updated at the beginning of each year using your current account    balance and current life expectancy. This is the only method of the three that changes the payment amount as your account value changes. It may be the most suitable method if you expect the value of your account to change significantly.

2. Fixed amortization method: With this method, the amount to be distributed annually is determined by amortizing your current account balance over your single life expectancy or joint life expectancy with your oldest named beneficiary and an interest rate. The interest rate you specify helps determine the amount of the payment; it cannot exceed 120% of the federal mid-term rate.

Unlike with RMD, the payment amount does not change; once the payment amount is determined with this method, it remains the same for all distributions.

3. Fixed annuitization method: This is the most complex method. It uses an annuity factor to calculate your payment, along with the account balance and an interest rate. The annuity factor is calculated using Appendix B of Ruling 2002-62 and is based on your age at the time of the calculation. Again, the amount of payment does not change once it is determined.

As you can see, the methods for determining the payment amount are complex and must be followed exactly. You should consult a qualified tax or financial advisor to determine your payment method if you decide to go this route.

Additionally, this provision is suitable for those with substantial IRA account balances (e.g. $1 million or more). That’s because it is quite possible to draw down your account with these payments, leaving you with the prospect of outliving your money. If your IRA balance is lower, or you have other income sources, this may not be suited for your situation.

The IRS rules do allow for a one-time switch to the RMD method from one of the other two methods. This can be useful to prevent drawing down your account, in case your account balance is fluctuating more than you had expected.

See the IRS website for more information about 72t distributions.




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