What Are 72(t) Payments and How Do They Work?
Learn how IRS section 72(t) allows for penalty-free distributions from retirement accounts before age 59½ through a carefully structured payment plan.
Learn how IRS section 72(t) allows for penalty-free distributions from retirement accounts before age 59½ through a carefully structured payment plan.
Accessing retirement funds before reaching age 59½ results in a 10% early withdrawal penalty from the IRS. However, Section 72(t) of the tax code offers an exception, allowing penalty-free access to retirement savings through Substantially Equal Periodic Payments (SEPP). These payments provide a structured way to receive a portion of your retirement funds annually without the penalty.
The purpose of a 72(t) plan is to create a steady income stream from retirement accounts for early retirees or those with specific financial needs. It is not a lump-sum withdrawal but a series of calculated distributions sustained over a required period.
To begin a 72(t) payment plan, you must be under age 59½ and have a qualifying retirement account. Eligibility is not based on employment status, so you can be working, unemployed, or retired. The provision is designed for those who need to access retirement savings before the standard age.
Many retirement accounts are eligible for 72(t) distributions, including:
For employer-sponsored plans like a 401(k), the account holder must have separated from service with that employer to begin SEPP distributions from that account.
Roth IRAs can be used for a 72(t) plan, but the tax rules are more complex. While Roth contributions can be withdrawn tax-free, distributions of earnings are different. If you take distributions of earnings from a Roth IRA under a SEPP before the five-year holding period is met, those earnings are subject to income tax, though the 10% penalty is still waived.
Once a SEPP plan begins with a specific account, no additional contributions or rollovers can be made to that account for the entire duration of the payment schedule. Because of this restriction, many people segregate the funds for the 72(t) plan into a separate IRA to avoid disrupting their other retirement savings.
The IRS requires that the annual distribution for a 72(t) plan be calculated using one of three approved methods. These methods are based on the account holder’s life expectancy. The chosen method determines the payment amount and whether it will be fixed or change annually.
The first option is the Required Minimum Distribution (RMD) method. The annual payment is determined by dividing the prior year-end account balance by a life expectancy factor from an IRS table. Because the payment amount is recalculated each year, the distribution will fluctuate based on the account’s performance and the updated life expectancy factor.
A second option is the fixed amortization method. This method calculates a fixed annual payment that will remain the same for the plan’s duration. The calculation is based on the account balance, a life expectancy factor, and a reasonable interest rate. The interest rate used cannot be more than 120% of the federal mid-term rate (or 5%, whichever is greater) for either of the two months before payments begin.
The third method is the fixed annuitization method, which also results in a fixed annual payment. The calculation involves dividing the account balance by an annuity factor derived from IRS-provided mortality tables and a reasonable interest rate. This interest rate is subject to the same limitations as the amortization method, and the resulting payment is consistent each year.
While the amortization and annuitization methods produce a fixed payment, the IRS permits a one-time, irrevocable switch to the RMD method. This can be advantageous if the account value has decreased significantly, as switching to the RMD method would result in a lower required distribution. No other changes to the calculation method are permitted once the plan is initiated.
Once a 72(t) payment plan is initiated, it is governed by strict rules. The primary rule is the duration requirement: payments must continue for a minimum period defined as the longer of five full years or until the account owner reaches age 59½. For example, an individual who starts a plan at age 52 must continue payments until they are 59½. Someone who begins at age 58 must continue payments for five full years, until age 63.
The plan is defined by its “substantially equal” nature. Once a calculation method is chosen and the payment amount is established, it cannot be modified. Making additional withdrawals, failing to take the required distribution, or altering the payment amount in any way not sanctioned by the IRS will break the plan and trigger penalties.
The consequences for breaking the rules are significant. If the payment schedule is modified, the IRS will impose a “recapture penalty.” This penalty retroactively applies the 10% early withdrawal penalty to all distributions taken from the beginning of the plan. The IRS will also charge interest on those penalties.
There are very few permissible changes to a SEPP plan. The plan terminates without penalty upon the death or disability of the account owner. Outside of these specific circumstances, the payment schedule must be maintained precisely as it was established.
There is no formal IRS application to start a 72(t) plan; the responsibility is yours to ensure it is correct. First, select one of the three approved calculation methods to determine your annual payment. Then, contact the financial institution holding your retirement account to arrange for the distributions.
Your financial institution will issue payments on your requested schedule, such as annually or monthly. At year-end, the custodian reports these distributions to you and the IRS on Form 1099-R. Box 7 of this form will likely contain distribution code ‘1’, indicating an early distribution.
To avoid the 10% penalty, you must file Form 5329, “Additional Taxes on Qualified Plans,” with your annual tax return. On this form, you report the total distribution and enter the exception code for SEPPs on the correct line. This informs the IRS that the distribution is part of a valid 72(t) plan and is exempt from the penalty.
You must file Form 5329 each year you receive distributions to claim the exception. It is also important to maintain records of your payment calculations and the distributions received. The IRS may request these records to verify the plan’s compliance.