What Is the 72t Tax Code for Early Withdrawals?

Accessing retirement funds ahead of schedule often involves a tax penalty. However, a specific provision in the tax code offers a structured way to utilize these savings before the standard retirement age without this extra cost. This method is governed by Internal Revenue Code Section 72(t), which provides an exception to the 10% early withdrawal penalty on distributions from qualified retirement plans. The rule allows individuals under the age of 59 ½ to receive a steady stream of income from their savings through what the IRS calls Substantially Equal Periodic Payments (SEPPs). This formal plan requires strict adherence to IRS guidelines to maintain its penalty-free status, and while distributions are subject to ordinary income tax, the additional 10% penalty is waived.

Eligibility for a 72(t) Plan

To utilize a 72(t) payment plan, the funds must originate from a qualifying retirement account. These include Individual Retirement Arrangements (IRAs), such as Traditional, Rollover, SEP, and SIMPLE IRAs. The provision also extends to distributions from employer-sponsored qualified plans, like 401(k)s, 403(b)s, and qualified pension plans. A condition for using funds from an employer plan is that the individual must have separated from service with that employer; an active employee cannot start a 72(t) plan with their current employer’s 401(k).

While Roth IRAs are eligible, the rules apply differently. Contributions to a Roth IRA can be withdrawn at any time, tax-free and penalty-free. Therefore, a 72(t) plan would only be necessary to access the earnings portion of a Roth IRA before age 59 ½ without penalty. Inherited IRAs also have their own distinct distribution rules and are not subject to the 10% early withdrawal penalty, making a 72(t) plan unnecessary for beneficiaries.

The decision to use a 72(t) plan is not based on demonstrating financial hardship to the IRS. Any individual with a qualifying account who is under age 59 ½ can elect to start a SEPP schedule.

Calculating Your Payment Amount

The IRS mandates that the amount of each payment be calculated using one of three approved methods. The choice of method has an impact on the annual payment amount and the flexibility of the plan. The necessary inputs for these calculations include the retirement account balance, a life expectancy table provided by the IRS, and, for some methods, a specified interest rate.

The first option is the required minimum distribution (RMD) method. This calculation is the simplest: the account balance at the end of the previous year is divided by a life expectancy factor from an IRS table. A feature of this method is that the payment amount is recalculated each year, meaning the annual distribution will fluctuate based on the account’s investment performance and the changing life expectancy factor.

Two other options, the amortization and annuitization methods, result in a fixed annual payment for the duration of the plan. These methods calculate a payment that will systematically liquidate the account balance over a specified number of years based on a chosen life expectancy table and an interest rate. Under IRS rules, this rate cannot be more than the greater of 5% or 120% of the federal mid-term rate for either of the two months immediately preceding the month payments begin. The IRS does permit a one-time, irrevocable switch from either the amortization or annuitization method to the RMD method.

Rules and Commitments of the Payment Plan

Initiating a 72(t) plan involves a long-term commitment governed by strict IRS regulations. The distributions must continue for a minimum period, which is defined as the longer of five full years or until the account owner reaches age 59 ½. For example, if an individual starts a plan at age 52, they must continue taking payments until they are 59 ½. If they start at age 56, the payments must continue for five years, until age 61.

Once a payment schedule begins, it is subject to a “no modification” rule. The account owner cannot alter, stop, or take additional distributions from the account that is subject to the 72(t) plan. Any deviation from the established SEPP schedule will bust the plan. This includes making additional contributions to the account or rolling funds into it.

The consequences for breaking these rules are retroactive. If the payment schedule is improperly modified, the 10% early withdrawal penalty is reinstated on all distributions taken under the plan from the very first payment. In addition, the IRS will also charge interest on the penalties from the years the distributions were originally taken.

Initiating and Reporting Your 72(t) Distributions

The process of starting a 72(t) plan does not involve any pre-approval or application with the IRS. Instead, the individual works directly with the financial institution or custodian that holds their retirement account. After selecting a calculation method and determining the payment amount, the account owner must provide formal instructions to the custodian to distribute the specific amount on a regular basis, such as monthly or annually.

At the end of the tax year, the custodian will issue a Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form reports the total amount distributed during the year. The custodian will likely enter distribution code ‘1’ (Early distribution, no known exception) in Box 7 of the form, which is standard practice and does not mean the penalty cannot be waived.

It is the taxpayer’s responsibility to claim the exception to the 10% penalty when filing their federal income tax return. This is done by filing Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” On this form, the taxpayer will report the total distribution amount and enter exception code ’02’ on the designated line to waive the penalty.