What it means
Normally, taking money out of an IRA or a workplace retirement plan before age 59 and a half triggers an extra 10% tax on top of regular income tax. Section 72(t) of the Internal Revenue Code lists exceptions, and one of them allows "substantially equal periodic payments", often shortened to SEPP (a series of regular withdrawals calculated by an approved formula).
People use it to fund an early retirement or a gap between jobs without waiting for the normal age. The payments must continue for at least five years or until the account owner reaches 59 and a half, whichever period is longer.
Someone who starts at age 52 is therefore committed for roughly seven and a half years, while someone who starts at 57 is committed for five. Stopping early, taking extra money out or changing the amount, other than because of death or disability, generally means the 10% penalty is applied retroactively to every payment already taken, plus interest.
There are three accepted ways to calculate the payment. The required minimum distribution method divides the account balance by a life expectancy factor each year, so the amount changes annually and is usually the smallest.
The fixed amortisation method and the fixed annuitisation method both produce one level payment that stays the same every year, and they usually give a larger figure because they use a stated interest rate and a life expectancy table. For a business owner or finance manager, the rule matters because it creates a long, rigid commitment of cash flow from a personal asset.
The account must also be invested sensibly, since a poor market year does not reduce the required payment under the fixed methods. Running out of money in the account before the schedule ends is a real risk that planners model carefully.
Rule 72(t) is a US rule and applies to US retirement accounts. The interest rate ceiling for the fixed methods, the life expectancy tables and the plan-specific conditions are set by the tax authority and can change, so anyone using the rule should confirm the current guidance with a qualified adviser before taking the first payment.
In practice
Real-world examples.
Example
A 55-year-old software engineer takes a career break after selling a start-up stake and has no wages for a few years. She sets up a Rule 72(t) schedule on her $500,000 IRA to cover living costs, knowing she must keep taking the same calculated payments until she is 60.
Example
A 57-year-old manufacturing manager is made redundant and wants a modest income from a $300,000 account. Because he is already close to 59 and a half, his commitment is the five-year minimum, which ends when he is 62.
Example
A self-employed consultant starts a fixed amortisation schedule, then needs a lump sum for a tax bill and withdraws an extra $20,000. The extra withdrawal counts as a modification, so the 10% penalty is applied to all earlier payments with interest.
Formula
Calculation
Required minimum distribution method: Annual payment = Account balance at the end of the prior year / Life expectancy factor for the owner's age.
Suppose a 52-year-old has a retirement account worth $624,000 and the published life expectancy factor for the chosen table is 39.0. The first-year payment is $624,000 / 39.0 = $16,000. If the account has grown to $637,000 a year later and the factor falls to 38.0, the second-year payment is $637,000 / 38.0 = $16,763 (rounded to the nearest dollar). The payments must run until the owner reaches 59 and a half, which is about seven and a half years, because that is longer than five years.Case study
Seen in the real world.
Elena Ruiz is an entirely fictional operations director who leaves her employer at 53 with $720,000 in a rollover IRA and no plans to work full time again. She wants about $20,000 a year until she can claim other income at 60 and a half, and her adviser in this illustrative story proposes a Rule 72(t) schedule rather than a series of one-off penalised withdrawals.
Her adviser runs all three methods and finds the fixed amortisation method gives a payment of $26,000, which is more than she needs, while the required minimum distribution method gives $18,500 in the first year. Elena chooses the required minimum distribution method because it flexes with the account and leaves her more capital if markets fall.
Two years in, she is tempted to withdraw an extra $10,000 for a kitchen renovation. Her adviser shows that a single extra withdrawal would trigger the retroactive 10% penalty on everything taken so far, so she borrows against her home instead. The illustrative lesson is that the rule rewards patience and punishes improvisation.
Watch out
Common mistakes.
- Assuming the 10% penalty is the only tax, when every Rule 72(t) payment is still taxed as ordinary income.
- Changing the amount, adding extra withdrawals or stopping the schedule early, which brings back the penalty on all earlier payments with interest.
- Putting a very large account balance into the schedule when only part is needed, instead of splitting the money into a separate account sized to the income target.
Questions
People also ask.
How long must the payments continue?
At least five years or until the owner reaches 59 and a half, whichever is longer.
Which accounts can use Rule 72(t)?
IRAs, and employer plans such as a 401(k) once the owner has left that employer, although the plan rules should be checked first.
Can the payment be changed once it starts?
Only in limited cases, such as a one-time switch to the required minimum distribution method under the tax authority's guidance, or following death or disability.
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