Did you know that you can use a 72t distribution to get early access to your 401(k) or most any other retirement account before age 59-1/2 … WITHOUT having to pay a penalty?
One of the biggest obstacles we face when we’re saving for retirement is the rule that we have to wait so long in order to finally use it.
For years, I had a goal to retire early (long before age 60).
But I was completely stumped by how I was actually going to be able to take money out of it.
I remember being in my young 20’s and thinking “what good is using a 401(k) if I have to wait almost 40 years to get my money back out”?
Fortunately, not only did I wise up and realize that saving your money in a 401(k) is a hell of deal (when you look at how much your saving in taxes and count in employer matching), but I also failed to understand:
You don’t necessarily have to wait until age 59-1/2! There is a way around this rule without having to pay the penalty, and it’s called a 72t distribution.
Here’s how it works and how you can use one safely in your plan to reach financial freedom … way, way, way before age 60!
What is a 72t Distribution?
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. Here’s a link to the official IRS FAQ.
You can do through taking what is called “substantially equal periodic payments” (also called SEPP). Here’s how they work.
You first choose from one of three distribution options:
- Required Minimum Distribution – Distribution is found by dividing the account balance by the life expectancy of the tax payer and beneficiary. The amount changes year to year.
- Fixed Amortization Method – Calculated as an annuity based on the tax-payer and beneficiary’s age versus a mortality table. The amount is the same each year.
- Fixed Annuitization Method – Calculated by dividing the account balance against the life expectancy of the tax-payer and beneficiary. The amount is the same each year.
As you can guess, each option will result in a different amount of distribution you can take.
Once they start, you have to keep taking the withdrawals until you turn age 59-1/2 or until 5 years have passed, whichever is longer.
Ordinary income taxes are paid on the distributions; just as they would be when you would withdraw them normally after age 59-1/2.
72t Distribution Example:
Let’s say you’re 50 years old and have a nest egg of $1,000,000 saved inside my 401(k). You’ve decided that you would like to retire early and need this money to start covering my living expenses.
With a 72t distribution, you could start making SEPP’s to accomplish this. Using this free online calculator, we can calculate that your maximum withdrawal per year from my 401(k) could be UP TO $42,936 per year for a minimum of the next 9-10 years (until age 59-1/2).
What if you were age 57 and started your 72t distribution? Now you’d have to continue your periodic withdrawals until age 62 to meet the 5-year minimum requirement (even though you’re over the age of 59-1/2).
Because of this 5-year or age 59-1/2 requirement, you have to be careful when using a 72t distribution to retire early. Once you start, you can’t stop before meeting the requirement, or the penalty will apply. Therefore, you need to be clever in choosing an amount that will not allow you to drain your retirement nest egg savings too quickly too early.
Two possible ways to handle this:
- You don’t have to choose the maximum interest rate allowed in the SEPP calculation. You can choose a lesser value which will result in lower payments and less drain on your nest egg over time.
- You also don’t need to take distributions from your entire nest egg. You could roll it over and divide it up into two IRA’s and then only start taking SEPP’s from one of the accounts. This would again preserve some of your savings for longer.
Another 401(k) Withdrawal Challenge (and Solution)
One of the BIG challenges about 401(k) plans that a lot of people don’t realize (sometimes until the last minute) is that even though the IRS says its okay to make 72t distributions, the plan itself may still not allow it.
I found this out myself with my old 401(k) plan. After learning about 72t distributions, I called the financial institution to see if it would be a possibility and the answer was “no”.
How can that be? Remember that when it comes to a 401(k) plan, much like in the U.S. how we have Federal and State laws, a 401(k) plan is made up of IRS and plan adminstrator rules.
Your plan administrator is generally your employer and they can rules for how the plan is handled. If for whatever reason they say “no” to early distributions, loans, etc., then those are the terms.
Related reading: What Are the 401(k) Withdrawal Rules for Early, Penalty-Free Access?
Do that mean you’re stuck without any options? Of course not!
A simple way around this challenge is to rollover your 401(k) balance to an IRA, and then proceed with the 72t distribution. This works because it changes all the control of the money from your employer to you!
A Helpful Phone Call with Vanguard
Years ago when I first heard about a 72t, I wanted to know more about them from the people who deal with them on a regular basis. So 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 401(k) into my Vanguard IRA 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 401(k) 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 401(k) but separate from my employer that a $25/year service fee would apply. Good 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.
You and your accountant need to keep exact records of your withdrawals so that this money can be tracked and reported properly to the IRS. Failure to comply or meet the minimum could result in having to pay the penalty.
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?
With a Roth IRA, 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 your Roth earnings penalty free as well.
Readers – Who has used a 72t distribution to take money out of their 401(k) or another retirement account? Did you find the process complicated, or is it easier than it sounds?
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