If you’ve been contributing to your retirement accounts diligently but are thinking about accessing your funds early, you may have encountered the terms 72(t) and SEPP. These concepts can provide a way to tap into your retirement savings without facing the usual penalties. Here’s what you need to know.
What Are 72(t) and SEPP?
72(t) refers to a specific IRS rule, part of the U.S. tax code, that allows penalty-free withdrawals from qualified retirement accounts before the age of 59½. Normally, withdrawing from accounts like your IRA or 401(k) before this age incurs a 10% early withdrawal penalty. However, under the 72(t) rule, if you follow a strict series of rules, you can avoid this penalty.
The mechanism by which you access these funds is called a Substantially Equal Periodic Payment (SEPP) plan. SEPP involves setting up a payment plan that must be followed consistently for a set period.
How SEPP Works
To take advantage of 72(t) rules, you must agree to receive distributions from your retirement account in “substantially equal periodic payments” for at least five years or until you turn 59½—whichever is longer.
There are three IRS-approved methods for calculating the payment amounts:
- Fixed Amortization Method: Payments are calculated based on your account balance, life expectancy, and a reasonable interest rate.
- Fixed Annuitization Method: This uses a formula to calculate payments based on the annuity factor and your life expectancy.
- Required Minimum Distribution Method: The payment is recalculated each year based on the account balance and life expectancy. This method typically results in smaller payments compared to the others.
Once you choose a method, you must stick with it. Modifying your payment plan before the SEPP period ends could result in penalties, including having to retroactively pay the 10% early withdrawal penalty for all the distributions you’ve taken.
Benefits of 72(t) and SEPP
- Early Access to Funds: For those wanting or needing to retire early, 72(t) allows access to retirement funds without penalties.
- Avoid the 10% Penalty: As long as you follow the SEPP plan, you can sidestep the early withdrawal penalty.
Drawbacks to Consider
- Lack of Flexibility: Once you start the SEPP plan, you cannot change the payment schedule, even if your financial situation improves or worsens.
- Risk of Running Out of Funds: If you start withdrawing too much too soon, you could deplete your retirement savings.
- IRS Scrutiny: SEPP plans must follow strict rules, and any missteps can result in hefty penalties.
Is 72(t) Right for You?
Choosing to set up a SEPP under 72(t) can be an attractive option if you plan to retire early, face unexpected financial challenges, or need liquidity for major expenses. However, the rigidity of the plan and the risk of running out of money make it crucial to carefully evaluate your long-term financial goals.
Final Thoughts
72(t) and SEPP provide a way to access retirement savings early without incurring penalties, but they require a clear strategy and a solid understanding of the long-term consequences. Before jumping in, consider consulting with a financial planner to ensure this approach aligns with your overall retirement strategy.
Never heard about this. Very interesting! It’s a game changer for FIRE people.
It’s a great option for early retirees. You can choose as few or as many accounts at a time. The only catch is you have to keep it until 59.5 or at least 5 years, so you can’t really change your mind once you start. Otherwise, you will be penalized.