Do you have an Individual Retirement account (IRA)? Do you need to access that account and are not yet 59 ½ to avoid the 10% penalty imposed by the IRS? If you answered these two questions, there might be an answer for you. Though it may not be ideal, it is an option. The answer is a 72(t) distribution from your IRA. But some several rules and disadvantages also make this option less appealing for IRA owners. After you read this and still want to pursue a 72(t) distribution, seek the assistance of a fee-only Registered Financial Consultant.
Background on IRAs
IRA comes in two types, and they are the Traditional and ROTH varieties. In a Traditional IRA, any contributions are made with pre-tax dollars meaning you were provided a tax deduction at the time of the contribution. A ROTH IRA is made with after-tax dollars, and all withdrawals are tax-free as the taxes were paid on the funds before being placed in the IRA. The type you decide to use will depend a lot in your age and the tax bracket you are currently and what tax bracket you think you will be in when you retire. These techniques as more about tax planning than anything as the government knows it will get paid roughly the same in income tax regardless of the type of IRA you chose to use. Then once you have opened the IRA, you must wait until age 59 ½ to make your withdrawals to avoid the 10% penalty the IRA imposes on early withdrawals. And now, under the new laws governing IRAs, you are not required to take Required Minimum Distributions (RMD) from a Traditional IRA until age 72 up from age 70 ½.
How to Use a 72(t) Distribution
First, know that the rules governing a 72(t) distribution are stringent and are meant to discourage their use by the IRS. After all, saving for retirement is meant just to be used in retirement and not sooner. But life happened as we all know, and sometimes the only option for many maybe tap into their IRA for much need funds. The basics of the 72(t) are that you must set up equal payments for at least five years or until you reach 59 ½ whichever is longer. Here are two scenarios on how this part of the distribution works. If you are 52 years old, you must make 7 ½ years’ worth of withdrawals from the IRA in equal amounts, regardless of if you need the money for that many years. And if you are 58 years old, you will have to take the distributions until you reach age 63 even though you are eligible to receive more at this point but not less. And while you are making these withdrawals, you are not allowed to make contributions to the IRA despite the fact you may have earned income and would thereby be eligible.
How to Determine the Distribution
This is where a Registered Financial Consultant will be beneficial, as this is where the process can become extremely complicated. There are three methods to determine your distribution payment, and all three are complex and rule intensive. The first is the easiest where you use an RMD method, While the easiest to calculate it also produces the smallest payments. This approach must be recalculated on an annual basis. The other two ways are much more complex, and you will need the assistance of a financial expert. They are methods that use a fixed amortization process and a fixed annuitization process where the amount in the account, in addition to forecasted interest rates, are used as well.
As a side note here, it may be best to set up a separate IRA account just for the use in the 72(t) distributions. That way, it will help keep the accounting more manageable and you will always know where you stand with the IRA.
The Rules
These are the starting rules of the 72(t), but the main thing is to know that once established, the amounts are set by the method you select to use. And then, the frequency of the distributions cannot be changed either once set. So before electing a 72(t) distribution, make sure you need the funds. You are not going to be in a position to make additional contributions to the IRA, and you have no other options as retirement accounts are designed to be used for retirement. That way, they are most effective in their use. Also, it is critical to remember that any withdrawals, penalty or not, from a Traditional IRA are taxed as ordinary income.
For additional information, please contact me or any other fee-only Registered Financial Consultant. And to join our email newsletter, please fill out the form below.
