You’ve spent decades contributing to a tax-advantaged retirement savings account. Now, for one reason or another, you want to withdraw your money.
Maybe a medical issue has pushed you into early retirement, or you need to take off a few years to be a caregiver for a parent. But fortunately, you have hundreds of thousands, maybe even millions saved up, that could help keep you afloat now.
You absolutely can withdraw that money … but if you’re not yet age 59½, you’re not only going to be liable for taxes on those withdrawals, but you’ll also face a 10% early withdrawal penalty that will further eat away at your nest egg.
Early withdrawal penalties serve to deter people from taking money out of their retirement accounts at too young of an age, kneecapping the funds that are meant to last them through their post-working years. But sometimes, there are financial situations that simply can’t wait. Fortunately, there are a few loopholes that help people from being penalized for needing money—and Rule 72(t) is one of them.
Read on, and I’ll explain Rule 72(t), show you how it works, help you determine whether you should take advantage of it, and list a few alternative steps you might consider if Rule 72(t) isn’t right for you.
What Is Rule 72(t)?
Typically, you must be at least age 59½ to take penalty-free withdrawals from an employer-sponsored retirement plan (such as a 401(k) or 403(b) plan) or individual retirement account (IRA).
Rule 72(t) is a nod to Internal Revenue Code section 72(t), which outlines the 10% tax penalty imposed whenever a taxpayer receives funds from a qualified retirement plan (which for purposes of Section 72(t) includes both workplace plans and individual retirement accounts), including its exceptions.
For instance, Section 72(t) explains that no 10% penalty will be applied when an employee reaches age 59½.
But that’s not the only situation in which the penalty goes away.
When people talk about Rule 72(t), they’re typically talking about a particular sliver of the section—specifically, Section 72(t)(2)(A)(iv), which says that anyone may avoid the 10% penalty if they take a minimum of five substantial equal periodic payments (SEPPs) or adhere to the payment schedule until age 59½, whichever is longer.
In other words, in theory, you could do this at age 25, 30, 35, 40 … you get the picture.
There are several limitations, however. Payments must be withdrawn on a specific schedule, based on one of three calculation methods you choose (more on this later). You can’t adjust the SEPP amounts, nor can you make additional withdrawals; doing so would subject you to the 10% penalty you’re trying to avoid. And once you begin withdrawing from the account, you can no longer contribute additional funds.
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Who Is Eligible for Rule 72(t)?
You must be under age 59½ to take advantage of this break, as adults at or over this age may already take penalty-free withdrawals. The retirement plans eligible for Rule 72(t) include 401(k), 457(b), 403(b) Thrift Savings Plans (TSPs), and IRAs.
Related: When Should You Take Social Security?
How Are Rule 72(t) Payments Calculated?
All Rule 72(t) calculations use life expectancy, as determined by the IRS. (You can see which tables should be used on IRS.gov.) That may be only your life expectancy, though in some cases, it will be the joint life expectancies of you and your designated beneficiary.
Generally, the older you are when payments begin, the larger the payment amounts.
Using your life expectancy number, you can choose which of the three following IRS-approved calculation methods you want:
- Required minimum distribution (RMD) method
- Amortization method
- Annuitization method
Let’s take a look at each method.
Related: What Are the Average Retirement Savings By Age?
Required Minimum Distribution (RMD) Method
The required minimum distribution (RMD) method is arguably the easiest to calculate. It’s simply your account balance divided by your remaining life expectancy (according to the appropriate IRS table). This tends to result in the smallest annual payment of the three methods. And the payment will change—every year, you must re-calculate based on your new account balance and your updated life expectancy.
Amortization Method
The amortization method calculates fixed payment sizes by amortizing a person’s account balance over their life expectancy, while applying a “reasonable” interest rate that’s not more than the greater of 5% or 120% of the federal mid-term rate. This method produces fixed annual payouts, and it typically generates the largest payments of all three methods.
Related: How Long Will My Savings Last in Retirement? 4 Withdrawal Strategies
Annuitization Method
The annuitization method is similar to the amortization method, but it uses somewhat different data. This method has the account holder divide their account balance by an “annuity factor,” which is based on average mortality rates from the IRS mortality table and “reasonable” interest rates. The annual payment, which is the same each year, usually lands somewhere between the RMD and amortization methods.
Example
You’re 55 years old, and you want to withdraw money early under rule 72(t).
You have a 401(k) with a $500,000 balance that you expect to earn 8% annually. The reasonable distribution interest rate is 5%.
Here are the annual distributions you could expect to receive according to each method:
- Required minimum distribution (RMD): $15,823 (note, this would change each year upon recalculation)
- Amortization: $31,807
- Annuitization: $31,428
Related: Should You Tap Into Retirement Savings After a Layoff?
Should You Use Rule 72(t)?
Taking advantage of Rule 72(t) increases one’s risk of outliving their retirement savings. Additionally, you still have the financial burden of paying income taxes on the distributions, you miss out on tax-deferred growth, and you can’t contribute more to the account after withdrawals begin.
That’s a long way of saying, “This is a risky choice. This shouldn’t be your first resort if you need money.”
However, in some situations, using Rule 72(t) can be useful. If you have ample retirement savings and need to retire early, Rule 72(t) would allow you to enjoy penalty-free income during your early retirement.
Related: How to Invest for (And in) Retirement: Strategies + Investment Options
Rule 72(t) Alternatives
Rule of 55
Another way to take penalty-free 401(k) withdrawals is by using the Rule of 55.
The rule allows you to start taking distributions from your 401(k) without the early withdrawal penalty if you have lost or left your job during or after the calendar year in which you turn 55. Taxes will still apply, of course, just like they would if you were age 59½ or older—you’re just dodging the penalty. (The Rule of 55 does not apply to IRAs and similar accounts, however.)
Other Listed Exceptions to the 10% Penalty
Depending on your circumstance, you might qualify for one of several exceptions to the 10% penalty. They include (but aren’t limited to):
- Up to $5,000 per child for qualified birth or adoption costs
- Up to $10,000 or 50% of account (whichever is less) for domestic abuse victims
- Any funds used after the total and permanent disability of the account owner
- Amount of unreimbursed medical expenses (>7.5% AGI)
The IRS has a full list of exceptions to tax on early distributions. All of the examples listed here apply to both workplace plans and individual accounts. But some exceptions are limited by account type.
401(k) Loans
If it’s permitted by your plan, you may be able to take out a 401(k) loan.
Like just about any loan, a 401(k) loan lets you borrow money from your retirement savings, and requires you to pay back that money (with interest) over time.
But you should only consider this route if you are confident you can pay back the loan and interest in a timely manner. Not repaying the full loan and interest will result in any unpaid amounts to be treated as a distribution, which will trigger any applicable taxes and penalties. Some plans require the loan to be paid in full if you exit your job. Also, the interest rate for 401(k) loans is commonly a percentage point or two higher than the current prime rate.
