Pre-retirees often wonder when their retirement funds can be used. For most retirement accounts, the answer is any time, but extra taxes may be incurred when withdrawing funds early. There is also an opportunity cost in the form of lost tax-advantaged investment returns that may make meeting one’s long-term retirement goals more difficult. This is the reason for the extra tax cost imposed on early withdrawals. Congress wants to discourage us from tapping retirement savings early so we do not risk running out of money in retirement. Congress also recognized that fully blocking early access to retirement accounts would discourage retirement saving, so some exceptions to the early withdrawal penalty were put in place. Here we review some of these exceptions, particularly Rule 72(t) which received an update earlier this year.

Funds can be withdrawn from a traditional or Roth IRA at any time but there can be negative tax consequences if withdrawals are taken before reaching age 59 ½. Withdrawals may be subject to tax and a 10% early withdrawal penalty. Employer-sponsored retirement plans may not allow early withdrawals, but most have a loan provision that allows for some penalty-free early access to funds, and plans may also allow for hardship withdrawals that allow penalty-free withdrawals in limited circumstances. Other exceptions from the 10% penalty tax include withdrawals taken to cover unreimbursed medical expenses, to pay for health insurance premiums when unemployed, to cover expenses for a permanently disabled account owner or due to the account owner’s death, to pay for qualified higher education expenses, to pay for a first-time home purchase (up to $10,000), to cover an IRS levy, and withdrawals taken by a military reservist or national guard member called to active duty for at least 179 days. For 401(k) plans, there is a special exception that exempts retirees who separated from service in the tax year they turned 55 acknowledging that some workers may be able to retire early.

The final exception also acknowledges this possibility. Rule 72(t) exempts early withdrawals from the tax penalty when they are made as part of a series of “substantially equal periodic payments.” The thinking here is that this type of withdrawal scheme would only be implemented by someone who was actually retired and needing access to their savings, so no early withdrawal penalty should apply. To qualify for the exception, withdrawals must be carefully structured to meet IRS rules. These rules require distributions to be calculated using one of three IRS-approved methods. Furthermore, the systematic withdrawals must not be altered until five years has passed, or until the account owner reaches age 59 ½, whichever is later. This may sound quite restrictive, but the combination optional payment methods, and the fact that the 72(t) payment plan can be applied to a single IRA or 401(k) account, provides for some early withdrawal flexibility.

The minimum periodic payment under Rule 72(t) can be calculated using an annuitization, amortization or Required Minimum Distribution approach. The annuitization and amortization methods both result in a fixed payout amount that must be sustained for minimum payout duration. The RMD method will produce variable periodic payments because the annual payout amount is based on the prior year ending account balance and a life expectancy factor which change annually.

The updated IRS rules (see Notice 2022-06) allow the annuitization and amortization payments to be computed using the greater of 120% of the Applicable Federal Mid-Term Rate or 5%. The 5% rate provides a floor that was not previously available. The result is a periodic payment amount that is significantly larger than wheat could have been implemented under prior rules which only allowed for use of an interest rate equal to 120% of the Applicable Federal Rate. For taxpayers using the RMD method, the new life expectancy tables can be used to compute the minimum withdrawal.

While 72(t) payment schedules require strict compliance with several rules for a minimum of five years, they do offer some flexibility since they can be applied separately to different retirement accounts. Still, the potential penalties necessitate careful planning. When cash is needed to fund early retirement, the goal is likely to generate the largest payment from the smallest retirement account balance. This balance is now smaller under the new 72(t) rules allowing early retirees to maintain larger tax-deferred balances in other accounts not subject to 72(t) withdrawals.

David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at 603-926-1775 or david@threebearings.com.

This article originally appeared on Portsmouth Herald: Money Talk: Need retirement funds early? Remember 72(t)