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401(k) Tricks to Retire Early Using Rule 72(t)

401(k) Tricks to Retire Early Using Rule 72(t)

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59 and a 1/2 years old can be a long time to wait to retire if you have been saving a significant portion of your income for decades. 59 and a 1/2 years old is also the age most people would say that you would need to be to withdraw money from your IRA, 401(k) and other tax advantaged accounts to avoid any penalties by the IRS. However, most people would be wrong. Code 72(t), Section 2, also known simply as ‘Rule 72(t)’ is the ticket to retiring early. Utilizing this provision in the tax law, a diligent saver can start taking money out of their retirement accounts prior to the age of 59 and 1/2 years old. In fact, they can take money out at any age provided they follow some critical rules.

Rule 72(t) General Structure and Uses

Withdrawing funds from an eligible retirement account will require you to receive them in what are called ‘Substantially Equal Periodic Payments,’ or SEPP for short. Additionally, the rule requires you to take at least one of these payments for five years or until one of 3 things happen: you turn 59 and 1/2, you are disabled, or you die.

There are a few other rules you will need to abide by. If all the rules aren’t followed, then you may find yourself having to pay the 10% penalty.

  • In addition to having to take payments for at least 5 years you must also ensure that you are taking a payment each year. If you sign up to take advantage of Rule 72(t) and change your mind a year or two in, then sorry about your luck… you still have to take the payments out of your retirement account.
  • You will still need to pay income taxes on accounts that haven’t been taxed yet. Essentially, if your account isn’t of the ROTH variety you were probably be expecting this already. There are certain exclusions, of course, for funds earned while in a qualified combat zone.
  • If you are trying to use this rule for a 401(k) then you can no longer be working for the employer who manages that account. This makes sense, since if you are withdrawing from your retirement accounts then you should be retired. If you are looking to work part time at the employer that manages your 401(k) look at tapping other assets such as an IRA.

Determining your required Rule 72(t) SEPP

To determine how much your SEPP is going to need to be you will need to first figure out which of the 3 IRS Life Expectancy Tables you will be using to make the calculation. At the end of the day, Congress designed retirement accounts as a replacement for pensions. The tax benefit given to individuals through advantaged accounts is still supposed to keep retirement in mind… thus, your life expectancy is a part of the equation. Below is quick description and link to the appropriate IRS Tables.

  1. The Single Life Expectancy Table (Appendix B. Table I)
    If you are single in the eyes of the IRS then this table applies to you.
  2. The Joint and Last Survivor Life Expectancy Table (Appendix B. Table II)
    If you have a spouse who is more than 10 years younger than you and you are in fact the sole beneficiary of the account you wish to apply Rule 72(t) then this rule is for you.
  3. The Uniform Table (Appendix B. Table III)
    This is for the rest of us. If you are unmarried or married to someone that is not 10 years younger than you where you are the sole beneficiary.

Once you have figured out which table to calculate your life expectancy it is now time to choose the type of method that will be used for payment calculation. There are 3 ways to calculate your SEPP. They are:

  • The Annuitization Method
  • The Amortization Method
  • The Minimum Distribution Method

Rule 72(t) Payment Calculation: Annuitization Method (Moderate Aggressiveness)

The annuitization method of calculating your SEPP for Rule 72(t) calculates an annual rate of withdrawal that doesn’t change from year to year (like the Amoritization Method below) but uses a formula that divides the account by the life expectancy using the tables from above. The balance that is divided is from the balance on the last day of the year prior. The amount derived cannot be greater than 120% of the federal mid-term rate.

Rule 72(t) Payment Calculation: Amortization Method (Most Aggressive)

The amortization method will result in payments that are the same over the period (remember, at least 5 years). Distributions will not be recalculated at any point. Whatever the amount the first payment is will be the same amount as the last payment. To make the actual calculation, you will need to look up the monthly federal mid-term rate to calculate the payment amount which is different data than what the annuitization method above uses. The rate is used to set a limit for which the SEPP can be maximized at. Long story short… you will need to use a calculator which you can find here.

This method is not flexible, and like the Annuitization Method, can only be switched once and only to the Minimum Distribution Method. If you are looking to live exclusively off the amount received from the Amoritization Method, you may find as the number of years increases, your purchasing power may drop significantly due to inflation. You will need to keep close tabs on your overall balance to make sure you don’t run out of money too soon.

Rule 72(t) Payment Calculation: Minimum Distribution Method (Most Conservative)

As its name implies, using the Minimum Distribution Method minimizes the amount that can be withdrawn. In addition, the amount may vary a bit from year to year. It is like the Amoritization Method; however, it is recalculated each year. This method can be switched to once from either of the other two methods since it is considered the most conservative. If another 2008 style crash happens, switching to this method may give you an opportunity to try and recover a bit. That said, I don’t think I would bank on this as a real risk mitigation plan… but it is an option.

Warning and Conclusion

I am not your financial advisor or accountant; however, I do recommend you talk to one that has your best financial interests in mind when considering topics as important as these. I wrote this article, as I write this entire blog, as an expression of my own opinion… which is wrong regularly. Using Rule 72(t) can be very powerful and certainly change how we may view our tax advantaged accounts moving forward but be careful… withdrawing your funds too early can and will leave you destitute in your golden years. Don’t underestimate how much money you will need because of a desire to retire early. That said, if you have the funds to retire, don’t pay the 10% penalty to the IRS unless you truly must. Use Rule 72(t) where it makes sense.


Guy Money

As a formally trained Data Scientist I find excitement in writing about Personal Finance and how to view it through a lens filtered by data. I am excited about helping others build financial moats while at the same time helping to make the world a more livable and friendly place.

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