Early IRA Withdrawals Can Be Penalty-Free
Individual retirement accounts have strict rules for depositing and withdrawing money. But there are exceptions, and one of them is attracting attention these days—“substantially equal periodic payments.” Often referred to as 72(t) plans, this option allows those under the age of 59½ to withdraw funds early from their traditional IRA accounts, for any reason, without paying the usual early-withdrawal penalty of 10% on top of the regular taxes.
The plans can be useful for people facing big expenses—but they come with a lot of limitations and potential drawbacks that are crucial to keep in mind. And investors must be careful before they take the plunge, because the plans represent a multiyear commitment. The plans—named for the section of the Internal Revenue Code that details their use, 72(t)(2)(A)(iv)—give investors a series of equal payments taken at least annually. The duration of a plan must be at least five years or until the person reaches 59½, whichever is longer.
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Why does the government offer this loophole in the first place? It realized people might face difficult situations that force them to tap extra funds before retirement—and, for many people, IRAs are their largest source of savings. At the same time, the government wants people to have money available at retirement, and to discourage one-time invasions of the account. That's why the plan doesn’t allow you to withdraw all the assets in your IRA, and why the distributions are broken down into periodic payments. A 72(t) plan is just one of the exceptions to the 10% early-distribution penalty for IRAs. Others include expenses for birth or adoption, higher education and first-time home purchases. What’s more, for 2020 only, the Cares Act created coronavirus-related distributions as another exception. (Early distributions also can be set up for certain withdrawals from other qualified retirement plans like 401(k)s and 403(b)s.)
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Another big consideration: Except for situations involving disability or death, any modification of the payment stream—such as withdrawing more or less than the calculated amount, adding to the account or rolling over funds into the account—will trigger a retroactive 10% early-distribution recapture tax. This harsh penalty for deviation from the early-distribution payment schedule thus affects both previous and current distributions during the existence of the plan. Example: If the IRA owner who began a 72(t) plan at age 50 withdraws any additional money when he or she is 55 years old, the 10% penalty would apply to the prior five years of payment. What’s more, Interest during the deferral period is also assessed.
What is possible, though, is splitting an IRA into two before withdrawals start, if such a move is financially desirable. By separating, one IRA can be used to calculate and distribute penalty-free 72(t) payments and the other can continue to be used as before. The result is that those who don’t need the entire amount in an IRA as an early withdrawal can divide it accordingly.
Due to the complexity and strict rules of 72(t) plans, it may be useful to consult a tax adviser to avoid mistakes. Even the IRS suggests, in Publication 590-B, that these plans “generally require professional assistance.”
https://www.wsj.com/articles/early-ira-withdrawals-can-be-penalty-free-11607004008 (subscription)