Rule 72(t): What It Is and How You Can Use It to Retire Early

• You don’t always have to wait until age 59 ½ to retire.
• There are some options at your disposal that allow you to tap certain accounts in specific ways without paying that dreaded 10% early retirement distribution penalty. 

One method is known as the Rule 72(t) Substantially Equal Periodic Payments (SEPP) provision. This rule essentially makes it so that you can take penalty-free withdrawals from IRAs and other accounts such as a 401(k) or 403(b) plan. There are important rules outlined by the IRS, so working with a CPA is critical so you don’t miss a step. 

What is Rule 72(t)?

Rule 72(t) is an IRS code that talks about exceptions to the 10% early withdrawal tax on retirement distributions. Section 2 of that part of the IRS code lists certain “SEPP regulations” that must be met in order to avoid the early distribution penalty. 

To take advantage of Rule 72(t), you as the owner of the retirement account must take at least five substantially equal periodic payments. Those payments are determined by your life expectancy according to the IRS’s methods. Moreover, there are three schedules from which you can choose to take your withdrawals. You must take withdrawals based on your selected schedule for five years or until you hit age 59½, whichever is later (unless you are disabled or die).

For example, if you start taking distributions using the SEPP method at age 53½ (six years before the retirement age for normal distributions), you must adhere to that payment plan until you hit age 59½. However, if you were to wait until age 58 (a year and a half before 59½), then you must continue with your SEPP to age 63. 

You must stick to the SEPP plan for the required amount of time otherwise you will face an IRS-imposed penalty on all withdrawals up to that time. It is also important to know that there is no minimum age for beginning a SEPP, but you cannot leverage this strategy with an active employer-sponsored retirement account. 

The Three Methods

There are three ways you can go about taking a SEPP from your IRA – you must choose one and stick to it (you cannot switch later on). While it may seem challenging to figure out which is right for you, there are online calculators to help get a sense of what could work best for your situation, but you should still work with a tax professional before choosing a SEPP option. Then teaming with an experienced financial planner to execute the SEPP per Rule 72(t) is wise. 

1. Required Minimum Distribution (RMD)

This method works similarly to how older retirees must take withdrawals from their accounts. The RMD method uses a dividing factor from the IRS’s single or joint life expectancy tables (either the Uniform Lifetime Table, Single Life Table, or Joint and Last Survivor Table), then uses that figure to divide the retirement account balance. The result is an annual distribution amount that will vary over time, but not by a large amount. If you want to withdraw just a small amount each year, then this option might be your ideal choice. 

2. Amortization

Do you understand how your mortgage works? Maybe? If you do, then you will have no trouble grasping the amortization method to Rule 72(t). Just like paying down your mortgage, you take your retirement balance, apply an interest rate, then create an annual distribution schedule based on your life expectancy.

3. Annuitization

Door number 3 of your SEPP decision works just like how an insurance company calculates annuity payout amounts. Simply take the most recent reported account balance then divide it by an “annuity factor” which is found on the IRS’s mortality table. What’s easy about both the amortization and annuitization methods is that they result in fixed annual withdrawals, but that also means they do not increase with inflation, though your IRA balance will likely rise over time. It takes careful planning to ensure your SEPP distributions can meet your cash flow needs.

An Example Using the Fed Mid-Term Rate (December 2022)

It helps to see an example of how this seemingly complicated IRS provision works. It’s really not that bad when you put some numbers to it. 

Suppose someone is 51 years old and has the ambition to retire early. We will assume she has an IRA balance of a cool $1 million as of the end of the prior calendar year. According to the IRS’s interest rate tables, she can take an annual distribution of no more than the greater of 5% or 120% of the “Applicable Federal Rate (AFR)” under the amortization method. As of December 2022, the mid-term AFR was 4.27%, so the max percentage she can do here is 1.2 times that amount, or 5.14%.

The math is now easy – she can pull $51,400 in the current year. (5.14% of her $1 million IRA.) 

A Savvy SEPP Strategy

While a SEPP withdrawal plan is strict in that you must choose one of three specific methods, you can plan ahead so that your annual distributions are the amounts you desire. After all, too big of an annual income could increase your tax liability beyond what you are comfortable with. Too paltry of a withdrawal, though, might not meet your spending needs. 

With 72(t), you can solve for the withdrawal amount desired, then segregate money specifically into an IRA to take SEPPs from. This is an indirect way to tailor your withdrawal amount. 

Other Options

There are a host of exceptions to the IRA early withdrawal penalty – you do not just have to look to Rule 72(t) and the SEPP. For instance, there are allowances if you have significant medical expenses, need to pay for health insurance, or face disability, and even young people can withdraw from IRAs penalty-free for qualifying higher education costs and a first-time home purchase. What’s more, you can retire at age 55 if you have an employer-sponsored retirement plan like a 401(k) or 403(b) with your current employer – we outline that opportunity here.

Bottom Line

Rule 72(t) and the SEPP strategy help folks who need to tap an IRA for hardship purposes or those who simply want to retire early without paying a 10% early distribution penalty. There are some loops to jump through, but a little planning and the right execution strategy can go a long way toward securing an early retirement. 

If you are curious about how Rule 72(t) can work for you, consulting with a CPA and/or an experienced financial advisor is a good first step.