May 24, 2024
When Eric Cooper, a 50-year-old early retiree, needed to tap his retirement savings before the age of 59 and a half, he faced the possibility of steep penalties.
But he found a way around it using an obscure IRS rule known as Section 72(t).
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By leveraging this rule, Cooper successfully withdrew $20,000 annually from his IRA without incurring the 10% early-withdrawal penalty.
The withdrawal bucks conventional wisdom about taking money out of your retirement vehicles before age 59.5. Usually, early withdrawals trigger stifling penalties, and they can slow the momentum of your portfolio as it barrels toward retirement, fueled by market rises and compound interest.
So why and how did Eric do it?
A quiet loophole
A diligent saver who was ready for a change, Eric told Business Insider that he decided to retire early and he needed a reliable source of income.
Knowing about early-withdrawal penalties for IRAs, and after doing some research, he found Section 72(t), which allows for penalty-free early withdrawals – known as Substantially Equal Periodic Payments – provided they follow a specific set of rules.
He calculated his SEPPs based on his life expectancy and started withdrawing $20,000 annually. This strategy gave him the necessary funds to support his early retirement while avoiding hefty penalties.
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Understanding Section 72(t)
SEPPs are calculated based on one of three methods:
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Required minimum distribution (RMD) method. Withdrawals are calculated annually by dividing the account balance by the individual’s life expectancy.
Fixed amortization method. Withdrawals are also determined using the account balance and life expectancy, but involving a slightly different calculation.
Fixed annuitization method. Withdrawals are based on annuity factor tables provided by the IRS.
Withdrawals must continue for at least five years or until the individual reaches 59.5, whichever is longer. For example, if Eric starts his SEPPs at age 50, he must continue them until he turns 59.5. If he begins at age 57, he must continue until he turns 62.
Here’s a sample calculation: Let’s assume you have $500,000 in an IRA and use the fixed amortization method with an interest rate of 2%. Using this method, your annual withdrawal amount might be calculated this way:
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- Account balance: $500,000
- Life expectancy: 34.2 years (based on IRS tables)
- Annual withdrawal: $500,000 / 34.2 = $14,619.
You could choose to adjust your withdrawal amount by selecting a different method or adjusting parameters within the allowed ranges. You can play with different scenarios using this calculator.
Is Section 72(t) right for you?
Utilizing Section 72(t) can be a smart move for some early retirees, but it’s not without its risks and downsides. Here’s a look at why it may or may not be suitable depending on your financial situation:
Advantages: The primary benefit is avoiding the 10% early-withdrawal penalty, preserving more of your retirement savings.
Disadvantages: SEPP withdrawals must be maintained for the required duration. Stopping or altering the payments can result in penalties and interest on all previous withdrawals. Of course, withdrawing funds early can significantly reduce the potential growth of your retirement savings.
You should also consider keeping your accountant and financial adviser on speed dial: Determining the correct withdrawal amount requires precise calculations and often professional guidance to avoid mistakes.
There’s a reason why Section 72(t) is seldom used. Getting it right can be complex and requires a thorough understanding of the rules. But it offers a valuable tool for early retirees like Cooper, providing a way to access retirement funds without penalties.
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Chris Clark is a Kansas City–based freelance contributor for Moneywise, where he writes about the real financial choices facing everyday Americans—from saving for retirement to navigating housing and debt.
