What Are the Rules for Tax Code 72(t) Payments?

Internal Revenue Code Section 72(t) provides a way for individuals to access funds from their retirement accounts before age 59½ without the 10% early withdrawal penalty. This is accomplished through a series of withdrawals known as Substantially Equal Periodic Payments, or SEPPs. These payments are an exception to tax law, allowing for penalty-free distributions from IRAs and other qualified retirement plans. The process is governed by Internal Revenue Service (IRS) regulations regarding how payments are calculated, how long they must continue, and the consequences for failing to follow the rules.

Calculating Your Payment Amount

The amount you can withdraw each year under a 72(t) plan is not a figure you can choose yourself. The IRS requires the use of one of three specific calculation methods to determine the annual distribution amount. Once you select a method for a specific retirement account, you must stick with it.

The Required Minimum Distribution (RMD) Method

The RMD method is the most straightforward of the three options. The annual payment is determined by dividing the prior year-end account balance by a life expectancy factor from an IRS-required table. Because both the account balance and the life expectancy factor change each year, the payment amount is recalculated annually.

This method produces the smallest initial payment compared to the other two options. The variable nature of the payment can be a benefit in years when the market performs well, leading to a higher payment, but it can also be a drawback in down markets, resulting in a smaller distribution when you might need it most. This method offers flexibility, as a one-time switch to the amortization or annuitization method is permitted without penalty.

The Amortization Method

The amortization method calculates a fixed annual payment for the duration of the SEPP plan. The calculation uses your account balance, a life expectancy factor from an IRS-required table, and a reasonable interest rate. The payment is determined by amortizing your account balance over your life expectancy, similar to a loan payment. You must select an interest rate that is not more than the greater of 5% or 120% of the federal mid-term rate for either of the two months before payments begin. For example, a 55-year-old with a $100,000 IRA balance, using a 5.00% interest rate and a single life expectancy of 31.6 years, would calculate a fixed annual payment of $6,361.

The Annuitization Method

The annuitization method also results in a fixed annual payment. This calculation is similar to the amortization method but divides the account balance by an annuity factor, which is derived from an IRS-specified mortality table and a selected interest rate. The same interest rate rules that apply to the amortization method are used here. This method provides a stable, predictable income stream for budgeting purposes.

Required Duration of Payments

A 72(t) plan requires a strict time commitment. Once you begin taking SEPPs, you are locked into the payment schedule for a specific period. Payments must continue for the longer of five full years or until you reach age 59½.

To illustrate, if you begin taking payments at age 50, you must continue them until you are 59½. If you start at age 58, the five-year rule applies, meaning you must continue payments until you are 63. The plan only terminates without penalty upon reaching the required duration, or in the event of the account owner’s death or disability.

Any deviation from the established payment schedule is considered a “modification” and breaks the plan. This includes taking a different amount than calculated or taking an additional withdrawal from the same account. You also cannot make new contributions or rollovers into the account being used for SEPP distributions, as this would also be a modification that invalidates the plan.

Consequences of Modifying Payments

Failing to adhere to the SEPP rules carries financial penalties. If you modify your payment schedule before satisfying the duration requirement, the tax protection offered by Section 72(t) is retroactively revoked.

The primary consequence is a “recapture penalty,” where the 10% early withdrawal penalty is retroactively applied to all distributions taken from the plan since its inception. For example, if you break the plan in its fourth year, the 10% penalty is assessed on every payment you received in years one, two, and three.

The IRS also charges interest on the recaptured penalty amounts, calculated from the tax year in which each distribution would have originally been subject to the penalty. For example, if you improperly took $10,000 per year for three years, you would owe a $3,000 penalty (10% of $30,000) plus accrued interest.

Tax Reporting for 72(t) Distributions

Properly reporting your 72(t) payments to the IRS is necessary to maintain the plan’s tax-advantaged status. Although the distributions are penalty-free, they are still taxable income and must be reported correctly on your annual tax return using specific forms to claim the exception.

You will receive Form 1099-R from your retirement account’s financial custodian. Pay close attention to the distribution code in Box 7. Custodians often use code ‘1’ (Early distribution, no known exception), which places the burden on you to prove you qualify for an exception.

To claim the SEPP exception, you must file Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts. In Part I of this form, you report the total amount of your early distributions. You then enter exception code ’02’ on the designated line to indicate you are not subject to the 10% penalty.