Distributions from IRAs are subject to a 10% early distribution penalty if withdrawn before reaching age 59 1/2. However, one way of getting money our of your IRA and not having to pay the 10% early distribution penalty if you are under age 59 1/2 is to process 72(t) distributions. However, in order to do so, a rigid schedule with many rules must be precisely followed. Any mistakes can result in a modification, triggering highly undesirable consequences. For this reason, 72(t) schedules should generally only be used as an option of last resort.
In order to qualify for the 72(t) exception to the 10% early distribution penalty, payments must generally continue for at least five years or until age 59½, whichever is longer. In addition, payments must be distributed at least annually and must be substantially equal. The payment formula generally cannot be changed and the payments cannot be stopped during the schedule unless the account owner becomes disabled or dies.
72(t) payments can be computed using either a single or joint life, but once the account owner selects single or joint life, they must stick with that choice throughout the 72(t) term. However, using the single life table will result in a higher 72(t) payment than if the joint life table is used. For this reason, the single life table is generally the preferred option.
If an IRA owner wishes to establish a 72(t) schedule, they may do so at any age, but similar schedules can only be established from company plans including a solo 401k plan after a plan participant separates from service or ceases self-employment in case of a solo 401k plan. What is more, once the 72(t) schedule is established, account balances cannot be changed by adding new funds or by taking additional funds out of the account, including rollovers or transfers into or out of the account.
If an IRA owner violates one of the 72(t) rules, they lose the exception to the penalty retroactively back to the first distribution they took. As a result, the 10% early distribution penalty is assessed on all distributions taken prior to age 59½. And, to make matters worse, it is assumed that the penalty was due for the year of the distribution, so IRS assesses interest on the “late” penalty payments.
Consequently, the 72(t) rules are only applicable to the IRA(s) from which the 72(t) payments are calculated. As such, if an IRA owners has more IRA money in an account than they need to produce a desired 72(t) payment, the account can be split before starting 72(t) payments. This way, only one of the IRAs will have to be subject to the rigid 72(t) rules, while others can remain intact for future use.