The rule of 72: What is it and how does it work?

It sounds arcane, but when you have significant savings tied up in retirement accounts, it pays to know about rule 72(t)—one way to avoid penalties for withdrawing money from these accounts before age 59½ . You may never need to use it, but it’s reassuring to know it exists. What’s more, it may make you feel better about putting more of your savings in these funds—especially if you’re afraid that if you really need the money you’ll pay heavily for accessing it.

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Early withdrawal from retirement funds can cost you

Typically, withdrawals from retirement accounts prior to age 59½ are subject to a 10% early withdrawal penalty. The reason: Retirement accounts are tax advantaged. In exchange for these tax benefits, you agree to lock up your money for a certain amount of time. If you need to access your funds prior to retirement age, there are very few exceptions that may allow you to bypass the 10% penalty. Rule 72(t) is one of them.

How rule 72(t) can help

Rule 72(t) allows for penalty-free withdrawals before retirement age using a series of substantially equal periodic payments (SEPPs). The rule is listed in the Internal Revenue Code under Section 72(t) of Title 26. And there are specific requirements about how you can determine how much you are permitted to withdraw and when. Here’s what you need to know.

What SEPPs are and how to calculate them under rule 72(t)

SEPPs are distributions that you take over your life expectancy (or the joint life expectancy of you and your designated beneficiary). A SEPP plan can help you avoid the additional 10% early withdrawal penalty if you have to take retirement distributions prior to age 59½.

There are three main ways to calculate your possible SEPP payments. These are not the only acceptable calculation methods, but they are the three methods automatically approved by the Internal Revenue Service (IRS).

1. Required minimum distribution (RMD) method.
2. Amortization method.
3. Annuitization method.

The details about each can help you determine which approach would make the most sense for you.

Required minimum distribution (RMD) method

The RMD method is the simplest way to calculate your potential 72(t) distributions. It divides your retirement account balance by your life expectancy based on one of these three IRS tables:

• Uniform lifetime table.
• Single life table.
• Joint and last survivor table.

This method is the only one that allows for varying annual payments. The payment amount is recalculated using the current account balance each year prior to distribution.

Amortization method

The amortization method uses your chosen interest rate to amortize your account balance over the course of your life expectancy based on one of the three tables above. If you use the joint and last survivor table, you would use the age of your oldest named beneficiary. This method provides a constant payment for as many years as you take rule 72(t) distributions.

Annuitization method

The annuitization method is the most complex. It uses your chosen interest rate and an annuity%20or%20IRA%20can%20offer.) factor equal to the present value of an annuity of $1. The retirement account balance is divided by the annuity factor to arrive at your annual distribution. This method provides a constant payment for as many years as you take rule 72(t) distributions.

Special considerations

Here are two important caveats if you are considering a SEPP plan under rule 72(t).

1. You can’t be an employee of the plan sponsor

If you are taking 72(t) distributions from an employer-sponsored account, you must have separated from employment prior to starting a SEPP plan. You cannot be working for the employer sponsoring your retirement account.

2. One SEPP per account

You can only have one SEPP plan per each retirement account in any one year.

Cautions about using rule 72(t)

Here are some negatives you need to be aware of when considering a SEPP plan under rule 72(t).

No more contributions or other distributions

Once you begin a SEPP plan under Rule 72(t), you can no longer make any contributions to—or withdraw funds from—the account other than the SEPPs. Balance changes due to investments are allowed, but you can no longer add or remove additional money from your account until you reach the IRS’s modification date.

No modifications before a certain date

The modification date of your SEPP plan will be the later of:

• Five years from the first date of SEPP distribution.
• The date you reach age 59½.

How to make the best use of rule 72(t)

Rule 72(t) is best for individuals who have retired early. The downside to taking distributions under rule 72(t) is that you can no longer contribute to your account or take out additional money. This means that your account balance will only be decreasing as you continue to take SEPP plan withdrawals—except for any increases due to investment earnings. This option is more appealing for retirees because you wouldn’t be contributing any additional funds to your retirement account anyway.

Should you use rule 72(t)?

SEPPs work best in certain circumstances. Rule 72(t) requires that you spread the distributions out over your life expectancy (or your life plus a beneficiary's life). This gives you regular income, but it also limits the amount you can withdraw in any one year.

If you have a large retirement account balance, the mandated withdrawal amounts may be sufficient for your needs. But what if you have a major financial hardship that requires a large retirement account withdrawal in the present? Rule 72(t) will not be particularly helpful if your account balance isn’t large enough to generate a significant payment.

Before setting up a SEPP, consider these other options that let you take out larger amounts and don’t require that you continue to take distributions over the course of five years or more. The IRS allows for penalty-free retirement withdrawals in very specific limited circumstances, including:

• For birth or adoption fees, up to $5,000 per child.
• After death or total and permanent disability of the plan participant.
• For disaster recovery in a federally declared disaster zone, up to $22,000.
• For medical expenses in excess of 7.5% of your adjusted gross income (AGI).

TIME Stamp: 72(t) is beneficial if you can commit to distributions over the long term

You should consider first whether you are able to commit to a series of SEPPs under rule 72(t) for the long term. You should also be aware that you can no longer add or remove funds from the retirement account once the plan begins until you reach the date at which you can modify your distributions. This date is the later of five years or when you reach age 59½. If you have an immediate financial hardship, be sure to review the other IRS-approved exceptions to the 10% early withdrawal penalty, which do not require ongoing payments over the course of many years.

If you have reviewed all your options and still want to set up a SEPP plan under rule 72(t), be sure to follow all the rules to avoid a potential recapture tax. If you have retired early and plan to live off your retirement account balance for the duration of your life, it may be a good strategy to begin a SEPP plan. Another benefit for early retirees is that you can budget your retirement goals based on your recurring payments.

Frequently asked questions (FAQs)

Can I still work while taking 72(t) distributions?

Yes. However, if you are taking distributions from an employer-sponsored plan, you must have ended your employment with the sponsor prior to taking 72(t) distributions. In other words, you can take 72(t) distributions from your 401(k) or 403(b) plan with a former employer while you continue to work for a new employer. You can begin 72(t) distributions from your traditional IRA, such as a Robinhood IRA, at any time.

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Can I stop 72(t) payments after five years?

You can modify your 72(t) payments after five years if you are also over the age of 59½. Rule 72(t) states that you can modify payments after the later of:

• Five years from the date of first SEPP payment.
• The date you reach age 59½.

If you are still under age 59½ when you have reached the five-year mark, you will still need to continue payments until you reach that age. If you reached 59½ prior to the five-year mark, you can modify your payments at that point.

Do you pay taxes on a 72(t) withdrawal?

You will pay taxes on your 72(t) distributions the same as you would in retirement. For example, you would still have to pay taxes on your 401(k), 403(b), or traditional IRA distributions because those retirement accounts are tax deferred, meaning you don’t pay taxes until funds are withdrawn. The benefit to rule 72(t) is that you can avoid the additional 10% early withdrawal penalty.

How much can I draw from a 72(t)?

The IRS limits the amount you can withdraw under rule 72(t) by dictating the interest rate that you can use to calculate your annual payments. The interest rate is limited to either a flat 5% or 120% of the federal midterm rate for the two months prior to taking a 72(t) distribution, whichever is greater. The idea is that you will still have retirement funds available for the duration of your life expectancy under a SEPP plan.