Access to a clients retirement plan is difficult before he or she reaches age 59. But in many cases, clients need access to their nest egg at an earlier age. Under IRC Section 72(t), clients have an opportunity to tap their retirement funds, without incurring the penalties associated with early withdrawal.
Congress intended taxpayers to utilize their retirement funds as long-term savings vehicles. To discourage short-term savings in tax-deferred vehicles, a 10% early distribution penalty was imposed on withdrawals prior to age 59. That 10% penalty, in addition to regular federal and state taxes, results in a total tax approaching 50%. Consequently, taxpayers are discouraged from easy access to these accounts.
In those cases where clients need to access their accounts, IRC Section 72(t) offers a number of exceptions that allow access to IRAs and retirement funds in certain situations. A key subsection, 72(t)(2)(A)(iv) allows for limited ability to access these accounts if the withdrawals are part of a series of substantially equal distributions, paid out over the individuals life expectancy (or joint life expectancy). This one exception is the focus of this article and will generally be referred to as the Section 72(t) exception.
As a result, IRC Section 72(t) opens up a number of opportunities for advisors working with clients. It comes, however, with its own set of requirements and financial implications (see sidebar).
Section 72(t) in Client Situations
Consider an example: John, a 47-year-old who wishes to buy a $200,000 vacation home. After a large down payment the monthly payments are $900. As a source of funds he segments $550,000 out of his $1 million retirement plan. Using reasonable tax, mortality, and earnings assumptions, that $550,000 provides him with the following pre-tax amounts. Under the Life Expectancy method his first year payment is $15,320 (increasing to $33,228 at age 59). The Amortization and Annuitization methods provide him with $41,477 and $43,290, respectively.
Here, the Life Expectancy method works best; less is drawn from the IRA account in every year. And the first year distribution, under that approach, provides him with $1,277 per month. After taxes, that withdrawal nets him just under the required $900 per month in the first year and, on a projected basis, for all future years. At age 59 he can stop these withdrawals. At that point in time, between the balances in the early distribution account and the account he never touched, he would have $1,915,118.
This same type of approach can also be applied to clients who are seeking a source of premium dollars. Very often, when planning for a clients estate, the IRA account with its double taxation issues becomes a source of both a problem and a solution. How? Drawing on the IRA account provides a source of funds for overall estate planning and has the effect of reducing the IRA account at death.
With this in mind, Section 72(t) may offer a mechanism to address both a clients estate tax and IRA issues. Who is the ideal client for this? Although they may be few in number, clients with large retirement accounts, who may not need all of their retirement funds and who are far-sighted enough to begin their planning before their 60s, may find IRC Section 72(t) to be the right approach.
Retirement Planning Under Section 72(t)
This Tax Code section also offers an attractive technique for some clients who seek early retirement. Clients taking early retirement can segment their IRA into two or three segments–a segment to help their early retirement cash needs, and a segment for long-term retirement growth.
For example, Jane, age 52, recently left an employer with an early retirement package after 20 years of service. She would like a change of career and industry, but is concerned that the new salary will not replace her income needs. She currently needs $3,000 a month to cover her mortgage, food and utilities. Although Jane has a pension, if she draws on it before age 62 she will see a steep reduction in benefits.
Section 72(t) offers a possible solution. Jane also has $1 million in her 401(k) that she plans to roll over into an IRA. If she segments $600,000 of that amount into an IRA intended for a Section 72(t) election she might be able to replace her income, thereby freeing herself to seek a new, possibly more fulfilling career, in a new industry without near term concerns about living expenses.
Here, the Life Expectancy Method falls short. The $19,169 first year distribution that her advisor calculated would only be $1,597/month. The Amortization and Annuitization methods work better. In fact, the Amortization method provides $46,960/year or $3,913/month. This leaves Jane with $2,739 each month, an amount very close to her needs.
