By Sarah Brenner, JD
Director of Retirement Education
Times are tough. Unemployment is high and bills are piling up for many. These realities have forced a lot of people to look for sources of extra cash. For many Americans, their IRA is their biggest, or maybe only, savings available. It may be tempting to consider tapping into it in these challenging times. Distributions taken before age 59 ½ are subject to a 10% early distribution penalty. However, there is an exception for a series of substantially equal periodic payments (often called “72(t) payments”). While this may seem like a good opportunity to access IRA savings penalty-free, here are 3 reasons why you may want to think twice before you start a 72(t) payment plan from your IRA.
1. There is not a lot of flexibility: Many times, those who are interested in 72(t) believe they can simply choose the amount they would like to take from their IRA each year. It’s not that easy. There are specific formulas that must be used to calculate 72(t) payments. If your IRA balance is small, the amount you can take may be disappointing and not enough to meet your needs. You cannot take more from your IRA if you need it. And, you cannot stop the payments if your financial situation improves before the payment plan terms ends. Any change to the payment stream (with limited exceptions such as death or disability) would be considered a modification and would blow up the 72(t) plan, resulting in penalties.
2. It is a long-term commitment: A 72(t) plan should not be entered into lightly because it is a long-term commitment. When you start 72(t) payments, you must continue them until you reach age 59 ½ and five years have passed. Both requirements must be met. So, if you are 40 years old, you are looking at about 20 years of 72(t) payments in most cases. That’s a long time and a lot can happen. You really need to be sure you want to be locked into the payment plan for long durations.
3. It is easy to make mistakes and penalties are harsh: Because the calculations for 72(t) payments are so precise and because they must go on for such a long time, it’s easy for mistakes to happen. When the payment stream is modified (with limited exceptions), the 10% penalty will apply to all the distributions taken before age 59 1/2. That could be years and years of distributions. Using our previous example with the 40 year-old individual who starts 72(t) payments, if those payments are modified in the year the IRA owner turns 50 that would mean the 10% penalty would apply to the prior 10 years of payments. To make matters worse, interest is also assessed. That is a harsh result and the IRS in a number of private letter rulings has been reluctant to grant relief even for honest mistakes.