If you’ve ever felt completely stumped by the challenge of the age 59-1/2 requirement when it comes to taking money out of your retirement savings, don’t! There is a way to pull this off without paying a penalty.
This topic came up in the comments of my re-do post about retirement income strategies. Fortunately one of the readers (thanks again Lucas!) brought up the little known strategy of using a 72t distribution to gain access to your money if you plan to take an early retirement (like I do).
What is a 72t Distribution?
In case you’ve never heard of this before, a 72t distribution (or 72t for short) refers to a section of the IRS tax code that allows savers the privilege of accessing their money without penalty through a method called substantially equal periodic payments (also called SEPP).
The way it works is like this:
- You pick a distribution based on one of three methods: Required Minimum Distribution, Fixed Amortization Method, or the Fixed Annuitization Method. Basically each one will yield you a different amount of distribution. You can read more about the details here or try out this calculator here to see how the numbers will be different.
- Once they start, you have to keep taking the withdrawals until you turn age 59-1/2 or 5 years, whichever is longer.
- Ordinary income taxes are paid on the distributions.
Like I said – this is fantastic if you plan to retire early and need to gain access to your funds. But it could also be dangerous for the longevity of your retirement savings if you take out too much or your investments don’t perform very well. Plus there are some other aspects of the process that could botch the whole process if not properly executed.
So who better to tell me exactly how I can pull this off without making a mess of things? How about the folks that are holding my money – the investment companies!
A Helpful Phone Call with Vanguard:
I decided to call Vanguard (where I have my IRA’s) and see what they had to say about the possibility of taking a 72t distribution. Here is what they had to say:
Let’s say in 10 years I decide to leave my job. If I want to rollover my 401k into my Vanguard account, is there a fee for that?
No, there are no fees. You’d just fill out a form and convert it to a Traditional or Roth rollover IRA. If you pick the traditional, than there won’t be any taxes. If you pick the Roth, then there would be taxes owed on the balance, and you’d have to pay them out of pocket for that year on your income taxes.
(Just to be sure, I also called my 401k provider and checked to see if they had any outgoing fees for moving my savings. It turns out they do: a onetime of $40. I also found out that if I were to keep the money in my 401k but separate from my employer that a $25/year service fee would apply. Go to know.)
Suppose I do the traditional IRA rollover and wanted to access a portion of this money using a 72t to receive SEPP’s. How would I go about this?
I’d strongly urge you to talk to a tax professional about calculating one of the 3 payment options under a 72t distribution. They will also be able to help you code your withdrawals when you file them on your income taxes.
You don’t have to fill out anything or notify Vanguard. Vanguard doesn’t keep track of any of this for you. You simply make an early withdrawal and then make sure you code it on your taxes correctly.
If I were to file for an SEPP, do you separate or partition a portion of my savings to cover these payments?
No. There’s no setting aside money or locking it away someplace safe. Your distributions simply come out of your normal investment account.
I currently have a Roth IRA with you guys. Suppose in 10 years I wanted to make some early withdrawals. Would I have to pay taxes and penalties?
You can withdraw the contributions anytime without penalty or taxes (since you’ve already paid taxes on this money when you invested it).
The earnings are different. If you just plan to use the money for regular expenses, then you will have to pay ordinary income taxes and the 10% penalty.
When you make your withdraws, your contributions come out first. Then come the earnings.
To avoid that 10% penalty, you could also use the 72t distribution to access it penalty free.
Why an IRA Rollover? Why Not Just Take an SEPP from My 401k?
Now you might be asking yourself why go through all this trouble with rolling over the 401k into an IRA? Can’t you just leave the money in your 401k and take a SEPP’s from that?
Well – I could. But I’m not sure if I want to.
I called my 401k provider to see if taking SEPP’s would be an option after I separate from my employer. He said that it was NOT.
I thought that sounded wrong, and so I did a little research. It turns out on the IRS website here and here that 401k plans do permit SEPP’s. Coincidently 403b plans also allow SEPP’s too. So what’s the right answer?
Perhaps there’s something else in my employer plan I don’t know about. Or perhaps the guy I was talking to didn’t know his stuff.
Regardless of the right answer, I do know that Vanguard charges much less in expenses than my 401k provider. Suppose my account balance at the time of retirement is $1M. Instead of paying 0.5 to 1.0% in expenses ($5,000 to $10,000), I could go with a lower rate of 0.05% to 0.3% ($500 to $3,000).
So for the time being, it looks like the route I have the most confidence in is the 401k -> Rollover IRA -> 72t distribution path.
Readers – Does anyone out there have any actual experience with 72t’s or SEPP’s? Did you find the process complicated or easier than people are making it sound?
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