When asked how to avoid penalties on premature distributions many financial advisors response would include something about a “72(t)” rule. 72(t) is actually a section of the IRS code that deals with the penalties associated with premature distributions of retirement accounts. Often when someone mentions a 72(t) distribution they are actually referring to a small part of the section that discusses the avoidance of a premature 10% distribution penalty tax that is tagged on to distributions prior to age 59 . But there is a lot more to this section of the code.
The most commonly referred to part of this section is actually subsection part 72(t)(2)(A)(iv) and specifically, this sub-section describes how to avoid the penalty by taking Substantially Equal and Periodic Payments (SEPP) based on one of three methods. Specifically, if distributions 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 expectancy) of the employee and beneficiary, the 10% extra tax described in section 72(t)(1) will not be applicable. Normally under section 72(t)(1), any retirement account distributions prior to age 59 will result in this extra 10% tax. But, by choosing one of three methods to establish an annuity style distribution, and maintaining that distribution method for at least 5 years or until 59 (whichever is later), the receiver of the distributions will avoid the 10% extra tax. The three distribution methods are referred to as the required minimum distribution method, the fixed amortization method, and the fixed annuitization method. The life expectancy tables, account balance, method chosen and the interest rate decided on, will determine the amount of the actual distributions. The interest rate is arbitrary but cannot be more than 120% of the current federal mid-term rate (actually either of the two months preceding the month in which the distribution begins can be used). A competent planner should be used to generate the rate based on the recipients needs and circumstances. Revenue bulletin Rev. Rul. 2002-62, 2002-42 I.R.B. pages 710-711, describes this type of distribution in more detail. One point that should be made is that the custodian of the account must submit the proper form each year to the IRS in order to maintain the account eligibility. It would be a good idea to keep a copy of the original form in the event the IRS claims it was not submitted (I have experienced this happening). One more note on this: I have seen various warnings on advisors websites about not setting this up correctly resulting in the account being depleted which would cause the 10% penalty to be imposed on all withdrawals, this is a false statement (maybe used as a scare tactic), the IRA states in paragraph .03(a) of the above mentioned revenue bulleting that if the payments are set up according to the rules and the account gets depleted there will be no additional penalties applied.
Another popular subsection is 72(t)(2)(A)(v) which applies to ERISA qualified, employer established, defined contribution plans (401(k), 403(b), 457, etc… ). The 10% penalty imposed on section 72(t)(1) does not apply to these accounts if the employee separates from the employer during the year in which the employee turns 55. No special distributions need to be set up, and the employee can take lump sum distributions as well. This rule does not apply to individual retirement plans so if you are interested in taking a distribution under this subsection then the monies must be withdrawn prior to rolling over that amount to an IRA.
Other subsections of this code waive the 10% penalty for death of the individual 72(t)(2)(A)(ii), total disability 72(t)(2)(A)(iii), medical expenses in excess of 7.5% AGI 72(t)(2)(B), health insurance premium payments(must be unemployed for a period to qualify) 72(t)(2)(D), higher education expenses 72(t)(2)(E), first time home purchase (limited to $10,000) 72(t)(2)(F), along with a few more obscure seldom encountered ones.
I hope this article has de-mystified the 72(t) world a little for you. I consider this information an invaluable part of the planning process. Applied properly, these codes can save valuable a retirement plan assets.