By Andy Ives, CFP®, AIF®
IRA Analyst
When a person under the age of 59½ needs access to his IRA dollars, there is a 10% early withdrawal penalty applied to any distribution, unless an exception applies. One of the many 10% penalty exceptions is a 72(t) “series of substantially equal periodic payments.” Due to the possibility of errors over the required duration of such distribution schedules, it is our opinion that establishing a 72(t) should be the last resort. However, sometimes life gets in the way and a person has no other options.
A 72(t) payment plan must continue for five years or until age 59½, whichever comes later. A person leveraging a 72(t) cannot simply choose whatever amount he wants to take. A calculation must be made to determine the allowable distribution amount. The calculation factors in items like the balance in the account, the person’s age and a particular interest rate. Three distribution “methods” have been approved by the IRS: required minimum distribution (RMD), amortization, and annuitization. Usually, the same distribution method must be maintained during the entire payment period. The goal is to use the method that produces the largest 72(t) payments with the smallest IRA balance. This typically results in selecting either the amortization or annuitization method, because the RMD method usually produces a smaller payment.
But what if a market downturn caused the balance of the IRA to severely decline, resulting in the annual 72(t) payments becoming a much larger percentage of the IRA balance? There is relief. IRS Revenue Ruling 2002-62 permits a one-time switch from either the amortization or annuitization methods to the RMD method. This may be appropriate in 72(t) situations where the IRAs has shrunk due to a stock market downturn.
Note that if the switch is made to the RMD method, it is permanent until the end of the original 72(t) payment period. Any other changes would be considered a modification and result in retroactive penalties. Also, be aware that, while 72(t) payments cannot be converted to a Roth IRA, the entire IRA from which the 72(t) payments are coming CAN be converted to a Roth IRA. If the IRA has lost substantial value, converting the account during a market downturn could be a wise tax planning decision. Just be sure to continue with the same payment schedule.
Example: David, age 58, has been consistently taking 72(t) withdrawals from his IRA for three years under the amortization method. With a recent market downturn, his investments have lost considerable value. His required 72(t) payments are now eating up a much higher percentage of his account. To reduce the draw on his IRA, David elects to switch to the RMD method to calculate the remainder of his 72(t) payments. David must still adhere to the original 5-year payment period and can make no other modifications during that time.
For anyone considering a 72(t) series of substantially equal periodic payments, please be hyper careful. The same holds true for anyone with an existing 72(t) looking to make the one-time switch outlined above. One false step and years of retroactive 10% penalties could come due.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/slottreport/72t-switching-methods-in-a-market-downturn/