The Internal Revenue Code encourages individuals to save for retirement by offering taxpayers the ability to invest for their ‘golden years’ through a variety of tax-favored retirement accounts such as IRAs, Roth IRAs and 401(k) plans.
But the tax benefits provided by these accounts don’t come without strings attached. Notably, in order to help ensure that the funds accumulated within a retirement account are actually used for retirement, IRC Section 72(t) generally imposes a 10% “early distribution penalty” on the pre-tax portion of any amounts distributed from a retirement account before the owner reaches age 59 ½.
Despite that general rule, however, Congress recognized that even where taxpayers contributed funds to a retirement account with the best of intentions, from time to time, individuals may have a legitimate need to access portions of their retirement savings prior to age 59 ½.
Accordingly, IRC Section 72(t)(2) provides a list of exceptions to the general rule that pre-59 ½ distributions are subject to the 10% penalty. Provided that a taxpayer meets one or more of these exceptions, they can distribute at least a portion of their retirement savings – at any age – without incurring the 10% penalty (though pre-tax portions of the distribution, having been excluded from taxable income when they were originally contributed or accumulated within the account, will still be subject to ordinary income tax in the year of the distribution).
Most of the exceptions outlined under IRC Section 72(t)(2) are designed to be narrow in application and generally require taxpayers to meet certain specifications to qualify. For instance, IRC Section 72(t)(2)(A)(iii) allows permanently disabled taxpayers to take penalty-free distributions from their accounts without a 10% penalty. Similarly, IRC Section 72(t)(2)(A)(v) allows an employee who separates from service during or after the year they turn 55 to access funds from the plan of the employer from which they separated without a penalty.
For individuals who don’t meet any of the more narrowly defined exceptions to the 10% penalty, though, IRC Section 72(t)(2)(iv) provides a much broader potential escape hatch through which taxpayers may be able to access retirement funds penalty-free before age 59 ½. More specifically, IRC Section 72(t)(2)(iv) stipulates that the 10% early distribution penalty will not apply to distributions which are:
“…part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary…”
These payments, commonly referred to as 72(t) Payments (or sometimes as SEPPs or SoSEPPs, after the term Series of Substantially Equal Periodic Payments from the IRC text), essentially allow anyone, regardless of age or other factors, to access a portion of their retirement account prior to age 59 ½ without a penalty.
To do so, however, taxpayers must adhere to a number of rules that have been provided by the IRS in guidance over the years. While the rules for 72(t) distributions have been left largely unchanged for decades, the recent release of IRS Notice 2022-6 updates the maximum interest rates and lifetime expectancy tables used to calculate distribution schedules. These changes can impact the maximum distribution amounts taxpayers can take, which means financial advisors with clients who may need early access to their retirement funds have an opportunity to help them navigate through updated options to set up 72(t) distribution schedules.
Rule overview
IRC Section 72(t)(4)(A) provides that, once an individual begins to take 72(t) distributions from a retirement account, they must continue doing so over the longer of five years or until they reach age 59 ½ (absent the taxpayer’s death or disability in the interim).
For example, while an individual beginning to take 72(t) distributions at age 57 will only have to maintain their distribution schedule for five years (because even though they would turn 59 ½ after 2 ½ years, the payment schedule must be kept for a minimum of five years), a taxpayer who begins such distributions at age 40 would have to maintain the schedule for nearly two decades.
After starting a series of 72(t) payments, the penalties for changing or canceling the payment schedule can be steep. IRC Section 72(t)(4)(A) provides that in the event a taxpayer modifies their 72(t) payment schedule before either the end of the five-year period or reaching age 59 ½ (whichever comes later), the 10% early distribution penalty will be retroactively applied to all pre-tax distributions taken prior to age 59 ½.
Furthermore, in these cases, the IRS will also retroactively apply interest to those amounts – that is, treating the penalty as if it had been applied at the time of distribution but had not yet been paid.
Example 1: In 2012, at the age of 45, Blathers established a 72(t) payment schedule to make periodic distributions from his Traditional IRA. Per the 72(t) rules, the schedule was set to conclude in 2026, when Blathers turns 59 ½.
Unfortunately, after properly taking distributions for a decade, in 2022 Blathers (at age 55) completely forgot to take his annual 72(t) distribution, thus breaking the schedule.
As a result of the error, the 10% penalty will be retroactively applied to all of Blathers’ prior distributions, from the first one in 2012 to the most recent in 2021.
Additionally, interest will apply to the 2012 10% penalty amount as though the amount had always been owed since 2012, but had not yet been paid, resulting in 10 years’ worth of interest applied to the 2012 payment. Similarly, interest will apply to the 2013 10% penalty amount as though the amount had always been owed since 2013, but had not yet been paid, resulting in nine years’ worth of interest applied to the 2013 payment. And so on.
Clearly, getting the timing of 72(t) payments correct is critical for avoiding early distribution penalties, but so too is correctly calculating the payment amount(s). Interestingly, the Internal Revenue Code itself provides little guidance on how to properly calculate 72(t) distributions, other than to state that they must be “substantially equal.” Thus, nearly all of the guidance that we do have, with respect to how to calculate 72(t) payments, comes from other sources, such as IRS Notices.
For instance, in Q&A-12 of Notice 89-25, published in 1989, the IRS first established three methods taxpayers could use to calculate their 72(t) payments:
- RMD methodology
- Amortization methodology
- Annuitization methodology
All three methods rely on the use of either a life expectancy or mortality table; furthermore, the amortization and annuitization methods require the use of a “reasonable” interest.
With the RMD method, the exact amount of a 72(t) distribution can vary from year to year (since distributions are recalculated on an annual basis using updated life expectancy factors and account balances), whereas the amortization and annuitization methodologies result in level distributions every year for the life of the 72(t) schedule.
Determining distribution
To determine the annual 72(t) distribution amount using the RMD method, the taxpayer’s current account balance is divided each year by an appropriate life expectancy factor, similar to the way typical RMDs are calculated.
In 2002, Notice 2002-62 was released and provided that taxpayers could use any of the life expectancy tables – the Uniform Lifetime Table, Joint and Last Survivor Table (“Joint Table”, or Single Life Expectancy Table – available at the time. Notice 2022-06, released in January 2022, provides for a transition from the old life expectancy tables, originally noted by Notice 2002-62, to the new life expectancy tables, released by the IRS in November of 2020 to reflect today’s longer life expectancies, and first effective for RMD calculations beginning in 2022.
More specifically, Notice 2022-06 stipulates that, for 2022, either the old or new life expectancy tables can be used when establishing new 72(t) schedules. Beginning in 2023, however, any new 72(t) payment schedules (established in 2023 and future years) will be required to use the new tables. Old 72(t) schedules calculated using the RMD method (those established in 2022 and earlier years), on the other hand, may switch to the new tables without the switch resulting in a modification.
Individuals who use the RMD method to calculate 72(t) distributions at the start of their payment schedule are not permitted to switch to another method and are therefore stuck using the RMD method for the life of the 72(t) distribution schedule.
Determining payments
Unlike 72(t) distributions calculated using the RMD method, distributions calculated using the amortization and annuitization methods remain level from year to year. When calculating such distributions using the amortization method, payments are determined by amortizing the individual’s account balance over a number of years (based on life expectancy determined from one of the approved tables) and using an appropriate interest rate.
The annuitization method, on the other hand, is determined by “dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the employee's age and continuing for the life of the employee (or the joint lives of the employee and designated beneficiary).” The annuity factors are provided by the IRS, and the present value is determined using a reasonable interest rate.
Notably, although neither the amortization nor annuitization method allows payments to be changed from one year to the next, an individual who begins their schedule with distributions calculated using either method can make a one-time switch to the RMD method at a time of their choosing, and use the RMD method (with no option to switch back to their original method) for the balance of the 72(t) schedule.
What’s a reasonable rate?
According to Notice 89-25, calculating 72(t) distributions with the amortization or annuitization methods required the use of a “reasonable interest rate” to set up the annual distribution schedule. Unfortunately, the Notice did not provide any guidance as to what would actually constitute a “reasonable” rate.
It will probably come as little surprise then, to learn that in the early days of 72(t) distributions, things were all over the place. With broad discretion to set the interest rates used to calculate the 72(t) payments with an amortization or annuitization schedule, some taxpayers and practitioners used wildly impractical interest rates to juice up their calculated distribution amounts and make higher (penalty-free) distributions from their retirement accounts than would have been possible with truly reasonable rates.
Ultimately, this led the IRS to publish a much more robust and prescriptive set of guidelines in 2002, appearing in Notice 2002-62. This Notice provided new details for calculating the 72(t) payment amounts under each of the methods first outlined by the IRS in Q&A-12 of Notice 89-25.
Taxpayers wishing to calculate their 72(t) distribution amounts using either the amortization or annuitization methods benefited from the guidance provided by Notice 2002-62. Notably, for the first time, the Notice defined the term “reasonable interest rate” in terms of the applicable Federal mid-term rates, as follows:
The interest rate that may be used is any interest rate that is not more than 120% of the federal mid-term rate (determined in accordance with §1274(d) for either of the two months immediately preceding the month in which the distribution begins).
However, with the release of Notice 2022-6, the maximum interest rate allowed was adjusted to the greater of 120% of the Federal mid-term rate, or 5%.
In the roughly 20 years following the release of Notice 2002-62, not much has changed with regard to the 72(t) rules. Then, in January 2022, the IRS released Notice 2022-6, which provided several taxpayer-friendly changes to the existing 72(t) rules.
The most significant change made by Notice 2022-6 updates the rules regarding the reasonable interest rate that can be used when calculating 72(t) payments under either the amortization or annuitization methods. Specifically, whereas Notice 2002-62 previously limited taxpayers to an interest rate no larger than 120% of the applicable Federal mid-term rate, Notice 2022-62 provides that taxpayers may use the greater of 120% of the applicable Federal mid-term rate, or 5%, to calculate 72(t) payments under the amortization or annuitization methods. Additionally, the 5% rate limit is effective for any series of payments starting in 2022 or later.
Consider, for instance, that 120% of the applicable Federal mid-term rate for January 2022 was 1.57%, while the same rate for February 2022 was 1.69%. Prior to the new guidance from Notice 2022-6, taxpayers beginning 72(t) schedules in March 2022 with distributions calculated using either the amortization or annuitization methods would have been limited to using an interest rate of no more than 1.69% (the higher rate from the two months prior to the month when the schedule began).
Example 2: Isabelle, age 50, has recently decided to use 72(t) payments as a way to access her IRA funds without incurring an early distribution penalty, and plans to make a series of annual distributions from her IRA starting in March 2022. Isabelle’s current IRA balance is $1 million.
Unfortunately, Isabelle is not aware of the new rules provided by Notice 2022-6, and calculates her maximum annual 72(t) payment using the 1.69% pre-Notice 2022-6 maximum rate.
After using each of the three methods and available life expectancy tables to calculate her potential maximum annual 72(t) distribution, Isabelle determines that the amortization method yields the highest possible annual 72(t) distribution of notice $37,156.28.
However, thanks to Notice 2022-6, taxpayers are now able to use an interest rate of 5% instead, producing a significantly higher 72(t) distribution from the same account balance than was possible under the previous rule.
Example 3: Digby is Isabelle’s identical twin sister. She, too, has recently decided to use 72(t) payments to access her IRA funds without a penalty. And she, too, has a current IRA balance of $1 million.
Thankfully for Digby, her advisor is aware of the new 5% interest rate limit for 72(t) and uses it to calculate her maximum annual 72(t) payment, to begin in March 2022.
After using each of the three methods and available life expectancy tables to calculate her potential maximum annual 72(t) distribution, Digby determines that the amortization method yields the highest possible annual 72(t) distribution of $60,312.23, an increase of more than $23,000 compared to her sister Isabelle’s distributions.
Investment gains and losses
In addition to clarifying the interest rate rules for determining 72(t) payments, Notice 2002-62 also provided clarity on a number of other matters. Notably, the Notice provided that, regardless of which method was used to calculate distributions, any changes to the balances of accounts from which 72(t) distributions were initially calculated could only arise from investment gains and/or losses and from the 72(t) distributions themselves.
In other words, any additional contributions to the account(s) or rollovers into or out of the account(s) would be deemed a modification of the 72(t) payment schedule – triggering the retroactive 10% early distribution penalty, plus interest.
When it comes to 72(t) planning, the name of the game is often pretty straightforward: to generate the largest possible (penalty-free) 72(t) distribution from the smallest possible balance.
But in practice, what does that mean? It means calculating new 72(t) distributions using the following parameters:
- The amortization method
- The Single Life Expectancy Table
- An interest rate equal to the greater of 5%, or 120% of the applicable Federal mid-term rate
Simply put, the combination of those factors will always generate the largest 72(t) payment.
From the examples above, it is clear that the larger the interest rate, the greater the maximum 72(t) distribution. Now, consider the graphic below, which illustrates the impact of the calculation method and life expectancy table on the maximum 72(t) distributions, using a constant 5% interest rate to calculate the payment amounts that could be generated with each method and life expectancy table (where applicable, as the annuitization method does not require the use of a life expectancy table) for a 50-year-old individual with a $1 million account balance.
Note that, with respect to the amortization and RMD methods, using the Single Life Expectancy Table produces the largest 72(t) distribution. That’s because, for any given age, using the Single Life Expectancy Table results in the lowest factor (i.e., remaining life expectancy) and therefore the highest annual payment.
And comparing the calculation methods used shows that, while using the annuitization method (which does not require the use of a life expectancy table) yields a competitive 72(t) payment amount, it doesn’t quite reach the payment that is possible when the amortization method is used with the Single Life Table, all else being equal.
Notably, the fact that the amortization method, when used with the Single Life Expectancy Table, results in the highest possible 72(t) payment holds true regardless of the IRA owner’s age, the account balance or the interest rate used in the calculation.
Splitting retirement assets
Ultimately, the point of establishing a 72(t) payment schedule for most individuals is to meet their cash flow needs before reaching age 59 ½. By raising the minimum interest rate used to calculate 72(t) payments, Notice 2022-6 increases the amount of penalty-free distributions that individuals can potentially take from their retirement accounts, thereby making it easier to meet their cash flow needs.
But the higher maximum 72(t) payment also makes it more likely that some individuals will face a different scenario: Their maximum payment amount will now be higher than what the individual needs to meet their cash flow needs – or, put another way, the individual does not need to use their entire retirement account balance to generate the payment required to meet their goals.
In these cases, the account balance should be split into multiple accounts prior to the establishment of the 72(t) schedule, leaving one account with just enough funds to produce the desired payment.
Example 4: Recall Digby from Example 3, who is 50 years old and has a current IRA balance of $1 million. Further recall that, using the new 5% floor rate for 72(t) calculations, Digby calculated a maximum annual 72(t) payment of $60,312.23.
Now, imagine Digby’s goal was to generate only $50,000 of penalty-free distributions from her IRA annually. Prior to the introduction of the 5% floor interest rate, Digby would not have been able to generate a 72(t) payment large enough to meet that goal, even when using her entire account balance to calculate the payment (recall that her sister Isabelle calculated a maximum payment of $37,156 using a pre-Notice 2022-6 maximum rate of 1.68%).
However, with the new 5% interest rate, she’s able to generate more than she needs to meet her cash flow goals. Accordingly, Digby transfers $170,981 from her $1 million IRA account to another IRA before establishing the 72(t) schedule using only the first IRA account (which now has a remaining balance of $1 million – $170,981 = $829,019).
With this strategy, using a 5% interest rate with the amortization calculation method and the Single Life Expectancy table, Digby calculates an annual 72(t) payment of exactly $50,000!
Furthermore, in the event that Digby has an unanticipated expense and needs access to additional funds, the $170,981 she transferred to the separate IRA would be available without the need to worry about creating a modification of the 72(t) schedule (though such distributions would, themselves, still be subject to the 10% early distribution penalty if not eligible for an exception).
Sure, Digby could have left her original account balance alone and taken only her desired $50,000 annual 72(t) payment in Example #4 above, instead of the full $60,312 amount calculated with a 5% interest rate (because, after all the IRS’s rules specify only the maximum payment – taxpayers can take smaller distributions if they so choose, so long as they remain consistent with the initial payment schedule). But, if she had done so, her entire $1 million IRA balance would have been tainted by the 72(t) schedule.
Minimizing payments
Notably, while the primary goal of 72(t) planning is often to create the highest possible 72(t) payment from a given account balance, it sometimes makes sense from a planning perspective to minimize the payment amount.
For example, a taxpayer who has already established a 72(t) payment schedule will occasionally find that they no longer need those payments. This may happen when a long-term unemployed person needs to tap into their retirement account to meet living expenses, but later finds gainful employment that makes the 72(t) payments unnecessary. Other cases such as an inheritance, a reduction in living expenses or a new relationship could also be the driving force behind a reduced need for 72(t) payments (and given that the payments create ‘extra’ taxable income for the taxpayer and deplete the account value, it is usually desirable to avoid depleting retirement accounts faster than necessary).
Unfortunately, as noted earlier, other than situations where a taxpayer dies or becomes disabled during the course of 72(t) payments, the distributions must continue until the natura’ end of the payment schedule to avoid triggering the 10% early withdrawal penalty.
But taxpayers wanting to minimize their existing 72(t) payments have one more tool at their disposal: the ability to make a one-time switch from either the amortization or annuitization method to the RMD method. Because, as the earlier chart showed, the RMD method produces the lowest possible 72(t) distribution of all the calculation methods (barring sustained dramatic growth within a retirement account after the establishment of a 72(t) schedule).
Which means that, in the rare cases when it makes sense to minimize 72(t) payments after they have already begun, a switch to the RMD method may not cease payments entirely, but it can at least reduce the impact of payments on the taxpayer’s taxable income and slow the depletion of pre-tax retirement assets.
Considering life expectancy
Just as the choice of life expectancy tables matters when it comes to maximizing 72(t) payments, the tables can also be used when the goal is to minimize the payments.
When comparing the old life expectancy tables to the updated ones it becomes immediately obvious that the new tables reflect today’s longer life expectancies. The result of those longer life expectancies is that distributions calculated using the new life expectancy tables will be smaller than those calculated using the old ones.
Thus, while individuals aiming to create the largest possible 72(t) payment should continue to use the old Single Life Expectancy Table, those who want to distribute the smallest amount possible should consider using the new life expectancy tables as soon as possible.
This applies to taxpayers switching from the amortization or annuitization methods to the RMD method, as well as to those already on the RMD method who wish to reduce their 72(t) payments even further.
In fairness, changing the tables won’t make a dramatic difference, as the factors between the old and new tables aren’t drastically different. But there is little cost to making the switch, while the savings in current-year tax dollars – and in the ability for funds to remain in the retirement account to compound tax-deferred over time – can be measured in real dollars.
Example 5: Marina is a 56-year-old taxpayer who began taking 72(t) distributions at age 50. At the time, she planned to permanently retire; however, she quickly found that she didn’t enjoy her time away from the office as much as anticipated and began working again at age 52. Accordingly, Marina no longer needs her 72(t) distributions to meet her living expenses.
Although she initially established her payment schedule using the amortization method, after returning to work Marina elected to make the one-time switch to the RMD method and has been calculating her 72(t) payments using that method ever since. Her current IRA balance is $800,000.
Under the old Uniform Lifetime Table, the life expectancy factor for a 56-year-old taxpayer is 40.7 years. Thus, for 2022, Marina’s 72(t) payment, using the old Uniform Life Expectancy table, would be $800,000 ÷ 40.7 = $19,656.
By contrast, the new Uniform Lifetime Table factor for a 56-year-old taxpayer is 42.6. Accordingly, Marina’s 2022 72(t) payment would be $800,000 ÷ 42.6 = $18,779. Thus, by using the new table, she would be able to reduce her 2022 72(t) distribution by $19,656 – $18,779 = $877.
Of course, once a taxpayer makes the switch to calculate their 72(t) payments using the new tables, they will continue to do so for the remainder of the 72(t) schedule. Thus, the bigger the account, and the further away the individual is from reaching age 59 ½, the greater the impact of switching to the new tables will be.
Ultimately, the key point is that, while 72(t) payment schedules are often used only in limited cases where retirement funds are needed before age 59 ½, there are still valuable strategies that advisors can use to optimize the payments for their clients’ goals. The recent guidance provided by Notice 2022-6 provides new ways to help individuals looking to establish new 72(t) schedules, as well as those looking to limit distributions from existing schedules.
