Are you considering using the 72t rule to take early withdrawals from your qualified retirement plan to avoid the 10% IRS penalty? As you regularly invest a portion of your paycheck in a 401k, IRA, or other qualified plans, you’ll likely realize that untaxed dollars will become taxable at a time when you need them the most.
While most hard-working Americans focus on accumulating wealth for retirement through financial planning, those who pay close attention will soon understand that your planning should be more about what you keep rather than what you accumulate.
If you have finally realized that because of government constraints on your retirement plans, such as the early withdrawal penalty, contribution limits, and required minimum distributions, it’s time to consider funding a life insurance retirement plan using indexed universal life insurance.
By using money in a qualified plan to fund a life insurance policy that is not subject to government constraints, tax liability, and penalty-free, you’ll keep much more of your wealth and give less of it to the federal government.
If this sounds like you, it’s critically important that you understand the 72t rules when funding your LIRP IUL.
What is Rule 72(t)?
72(t) is the IRS rule that allows individuals to withdraw funds from a qualified retirement account (401(k), IRA, etc.) before turning 59 ½ without being subject to the 10% penalty.
With rule 72t, you can access your retirement funds early. But there is a trade-off: you must take Substantially Equal Periodic Payments (SEPPs) every year for five years, or until you reach age 59 1/2 – whichever is longer.
The only exception for Rule 72t is if an individual becomes disabled or dies.
Consider the following examples:
- If an individual begins taking 72t required payments at age 50, they must continue taking these annual payments until age 59 ½ or for 9 ½ years
- If an individual begins taking 72t required payments at 55 years old, they must continue taking the annual payments until age 60 or for five years.
- If an individual begins taking 72t payments at 57 years old but then becomes disabled the following year, they will then be allowed to stop taking payments because they qualify for the disability exception.
Pitfalls of 72t
As with any IRS rule, there is a substantial list of pitfalls you must be mindful of. For example:
- If the individual alters or stops taking their 72t payments without a qualified exception, the IRS will enforce the 10% penalty on all of the funds you accumulated before turning age 59 ½.
- Any withdrawals you have taken will be considered taxable income, which would likely push the individual into a higher income tax bracket.
- Depleting qualified retirement accounts early could result in not having the funds needed to last through retirement years.
- An individual cannot add or take funds from their qualified plan for other reasons while the 72t payment plan is in effect. This means the account is frozen until the required payment plan is completed.
Using a 72t Calculator to Estimate Distributions
When deciding to take early distributions from a qualified retirement plan, a 72t calculator should be used. Most CPAs will double-check your math. Our 72t calculator will let you know exactly how much you can withdraw based on either the amortization method, minimum distribution method, or annuitization method.
The three IRS-approved methods to calculate life expectancy are explained below.
Amortization Method
The amortization method is a way to determine how much you should withdraw from your IRA account each year based on your life expectancy. This method ensures that you’ll withdraw the largest possible amount that is still reasonable, and the amount is fixed annually.
Minimum Distribution Method
The IRS minimum distribution method uses a single or joint life expectancy table to determine how much can be withdrawn from a retirement account each year. This method is nearly the opposite of the amortization method, as annual payments may vary from year to year.
Annuitization Method
By using the annuitization method, you can rest assured that your payments will be taken care of in accordance with the SEPP regulation. This method offers account holders a fixed annual payout, which is usually somewhere between the highest and lowest amount the account owner can withdraw.
Be careful. Making withdrawals from a qualified retirement account should be done with the support of an experienced financial advisor and your CPA. The IRS has established exceptions for certain circumstances, like disability or illness. If you don’t fit into any of the other categories of exceptions, then you may be able to use rule 72(t) if you have no other options.
Who Should Consider Taking Rule 72t Payments?
As was mentioned early on in this article, individuals who’ve realized that their qualified retirement plan(s) will be severely impacted by the tax liability when it comes time to withdraw the funds for retirement can benefit from funding an IUL Policy with taxable retirement funds.
Generally, this method is only recommended when after-tax money is simply not available to properly fund an Indexed Universal Life Insurance policy that will not be subject to typical government constraints and can deliver a tax-exempt income stream for retirement.
An experienced insurance advisor can illustrate how to withdraw funds from your qualified retirement plan and avoid the 10% IRS penalty. Use our IUL calculator on this page to get started.
Frequently Asked Questions about 72t Rules
What Are 72t Rules?
The 72t rules refer to a provision in the IRS code allowing for early, penalty-free withdrawals from an IRA or other qualified retirement account before age 59½. Under these rules, individuals can take substantially equal periodic payments (SEPP) from their retirement accounts. This exception to the early withdrawal penalty is crucial for those who need access to their funds before the typical retirement age but want to avoid the usual 10% penalty.
What Are the Requirements to Qualify for 72t Distributions?
To qualify for 72t distributions, the following requirements must be met:
- The account holder must take periodic payments based on an IRS-approved calculation method.
- Once started, the payments must continue for 5 years or until the account holder reaches 59½, whichever is longer.
- The payments must be calculated using one of three IRS-approved methods: Fixed Amortization, Fixed Annuitization, or Required Minimum Distribution (RMD) method.
Adherence to these guidelines is crucial to ensure compliance and avoid penalties.
Can 72t Withdrawals Be Used for Any Purpose?
Yes, 72t withdrawals can be used for any purpose. There are no restrictions on how the funds withdrawn under these rules are spent. This flexibility makes 72t distributions a valuable option for early retirees or those facing financial needs before reaching the typical retirement age. However, it’s important to consider the long-term impact on retirement savings.
What Happens If the 72t Rules Are Violated?
Violating the 72t rules can result in significant penalties. If the rules are not strictly followed for the entire duration of the distribution period, the IRS can retroactively apply the 10% early withdrawal penalty to all distributions taken before age 59½. This penalty is in addition to the regular income taxes owed on the distributions. Therefore, it’s crucial to carefully adhere to the rules and consult with a financial advisor or tax professional.
