How Does A 72T Work?

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

You may encounter a little hurdle while withdrawing funds from your IRA or 401(k) if you are fortunate (and well-prepared) enough to retire early. If you cash it in before you turn 59 1/2, you’ll have to pay a 10% penalty.

Substantially equal periodic payments (SEPP) are one way that many people who retire early get around this. It’s Section 72(t) of the Internal Revenue Code that gives rise to this regulation, hence its other name.

Withdrawals from a SEPP plan are exempt from the IRS’s 10% early withdrawal penalty if they meet certain requirements.

Payments for Substantially Equal Periods (SEPP)

SEPP Withdrawals

There are three options for calculating withdrawal amounts that are compliant with SEPP regulations.

  • Required minimum distribution technique. This is based on your life expectancy (or the joint life expectancy of you and your beneficiary) and your account amount. It’s reassessed by the IRS every year.
  • Fixed amortization approach. This calculates payments depending on your account balance and a chosen rate of return. Even if your account beats the rate of return, you still withdraw the same amount.
  • Fixed annuity technique. This utilizes an annuity factor from a mortality table with a fair rate of interest to create a fixed payout.

It’s up to you to decide which way of computation is most convenient, whether you’re looking to maximize your immediate cash flow, or save as much as possible for retirement. In most cases, the needed minimum distribution approach will let you withdraw less than the other two approaches.

You won’t have to worry about withdrawing too much money when the market is down because it is adjusted annually. To determine how much money you may withdraw using the amortization or RMD techniques, use Fidelty’s calculator.

Keep in mind that if you remove too much money, the IRS can regard it as an early withdrawal and apply the 10% penalty on the additional amount. If you want to avoid fines, having an accountant examine your numbers on a regular basis is a good idea.

You are only allowed to switch from one of the fixed ways to the RMD technique after you have begun participating in a SEPP plan. Otherwise, all of your prior payments would be ruled void and punished with the 10% penalty – so be cautious!

SEPP Plan Duration

You must participate in a SEPP for the greater of five years or until age 59 1/2. If you begin contributing to a SEPP plan at the age of 58, you must do so until the age of 63, even if by that time you will be eligible for retirement.

If you are close to retirement age and will soon be receiving a pension or Social Security check, you may want to reconsider whether you need the money for the whole five years. Always keep in mind that you will be required to keep receiving payments for a full five years, regardless of whether or not you actually require them.

In any case, if you are content with your SEPP payments as they currently stand, you are free to keep receiving them forever. At age 70 1/2, you must begin taking distributions from your SEPP, and such payouts must be at least as large as the minimum amounts allowed by law.

Premature termination of a SEPP plan is possible in the event of disability, death, or account exhaustion.

SEPP Withdrawal Taxes

Distributions from a Roth IRA taken out early in accordance with a SEPP will also be subject to taxation. Withdrawals from Roth IRAs are generally tax-free after age 59 1/2. With a SEPP, you can avoid paying the 10% early withdrawal penalty, but you’ll still have to pay income tax on your gains if you cash them out before you reach retirement age.

A Roth IRA allows for tax-free and penalty-free withdrawals of contributions once they have accrued for at least five years. Having multiple retirement accounts (or “account diversity”) might be helpful in this situation. You can avoid having to pay taxes on withdrawals from a Roth if you have funds in a standard retirement plan, such as an IRA or 401(k). You will still have to pay taxes on the money you remove, but they won’t be any more than they would be if you waited until you were 59 and a half.

Taking money out of your SEPP can raise your taxable income, which might have an impact on how much of your Social Security benefits you end up paying tax on. While this may not be a concern for people who retire early, it might be for those whose five-year SEPP period continues past age 62 or who have a spouse who receives Social Security benefits. Consult a tax professional if you expect your SEPP earnings to be sizable.

Other SEPP Policies

  • At least once a year, money must be transferred out of the account. Payments can be made as often as once a month, but they should always be the same amount.
  • Once a SEPP plan has been established, no contributions nor withdrawals (other than the SEPP dividend) are permitted.
  • No current employee may establish a SEPP under their current employer’s 401(k) plan.
  • If you receive a payout from your SEPP, you are required to withhold federal income tax at the rate of your choice. You may withhold $0.00 if you so want. The default amount withheld by your financial management firm is 10% unless you specify otherwise.
  • Withdrawals from a SEPP are considered taxable income, so it’s important to either have enough money withheld or pay quarterly anticipated taxes. If you don’t do either, you may wind up with a hefty tax bill and an underpayment penalty. If you have any additional taxable income, it is highly recommended that you see a CPA to help you figure out your options.

What If My SEPP Distribution Is Greater Than What I Need?

Prepare yourself so that you won’t have to take too much from your SEPP account if you just require a set amount of money throughout your five-year SEPP term. Obviously, you don’t want to forego tax-deferred growth if you can help it. Make sure you have enough money in your account to cover the withdrawal you wish to make by using a calculator.

If you have extra cash, roll it over into a new IRA. Then, transfer the remaining funds from the original IRA to the new SEPP. This will provide you access to the funds you need for the withdrawal you’ve specified. The SEPP distributions won’t be accurate until you run the numbers. Keep in mind that as long as the SEPP is in effect, you will incur penalties if you attempt to make contributions or withdrawals in excess of your SEPP amount.

Bottom Line

Thinking ahead and avoiding penalties when withdrawing from retirement savings requires careful consideration of the requirements. Make sure your CPA or financial adviser understands what a SEPP plan, or Section 72(t), is before you hire them.

While they may be well skilled in other areas, many professionals lack experience with this strategy. Setting up a SEPP plan properly might pave the route to an early retirement.

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