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.
Using 72(t) Jane is free to pursue another career. Her salary from that position can be used to boost future retirement savings. The early distributions from the $600,000 account can continue even beyond Janes age 59. Her future retirement savings can supplement that amount. Moreover, Jane still has $400,000 from her original 401(k) rollover untouched in another IRA account growing towards retirement.
For the right client, this can be a powerful planning device.
No planning technique is flawless and, in this regard, IRC Section 72(t) is no exception. Clients and advisors need to carefully analyze this section and its implications for both a clients short and long-term situation. This section is one where great care must be exercised, lest a client face a retroactive penalty.
It is important to keep in mind that, like much of IRA distribution planning, IRC Section 72(t) distribution guidance is derived primarily from Private Letter Rulings. These can never be cited by a client as authority to support his planning. This would particularly apply to recent rulings that have gained notoriety for allowing cost of living modifications to what would appear to otherwise be fairly inflexible payments.
Additionally, not all plans might allow for Section 72(t) distributions. Although this is fairly common with IRA accounts, other plans such as SEP IRAs do not allow for these distributions. Employer sponsored plans rarely allow for these types of distributions. Moreover, careful documentation and record-keeping is required as there is no clear mechanism by which to inform plan sponsors or the IRS of the 72(t) method a client selected.
Most importantly, keep in mind–at all times–that retirement accounts are intended as long-term savings vehicles. Making a 72(t) election has the effect of “robbing Peter to pay Paul.” It is critical to consider the impact of early withdrawals on a clients long-term savings program.
In the case of Janes early retirement example the numbers worked well and the income is likely to provide a base for support even well beyond her age 59.
In other cases this may have a severe impact on a clients retirement. For John, a 47-year-old who used $550,000 of his retirement assets to buy a $200,000 vacation home, the effect on his long-term retirement was more substantial. After tapping his retirement accounts early, their total value at his age 59 was projected to be $1,915,118. Had he not tapped his retirement funds, the value of the plan is projected to be $2,409,845–a $494,727 difference, for the purchase of a $200,000 vacation home. This type of impact must be weighed carefully with any client review of Section 72(t).
Section 72(t) is a powerful planning device when used properly with the right client. In many cases it can enhance client retirement objectives, be utilized for long-term estate and life insurance planning or enhance client lifestyles. However, as with any planning device, it must be examined carefully in light of each clients unique situation.
Mark A. Teitelbaum, JD, LL.M, CLU, ChFC, is second vice president, advanced sales at Travelers Life & Annuity, Hartford, Conn. He can be reached at mark.teitelbaum
Reproduced from National Underwriter Life & Health/Financial Services Edition, August 5, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.