Burk and Julie Rosenthal remember the day when they sat down with their client to discuss the 72(t) distribution plan he had already begun. He wanted to buy a local pub — all well and good. The problem was he wanted to bust his 72(t) to do so.

Another client wanted to bust her 72(t) distribution plan to buy a vehicle because she thought it smarter to take a chunk out of her retirement funds instead of taking out a traditional loan. There was even a client who wanted to break his 72(t) distribution schedule to pay off a home loan.

While all of these scenarios seem admirable in the sense that they are either helping someone to realize a dream, avoid debt, or pay off debt, according to the Rosenthals, these scenarios make little financial sense. “A vehicle is an asset that does not retain its value,” says Julie. “So, it makes little sense to modify a 72(t) distribution plan to pay for a vehicle. Paying off a home loan is sometimes a good thing but, in this case, it’s not a good choice, for the same reason it doesn’t make sense to take an early distribution to pay for a car. Busting a 72(t) distribution plan can have serious consequences.” In addition to drawing down a retirement plan, those who rock their distribution plan must also pay back taxes, back interest and retroactive penalties; these often exceed in value the reason the distribution was taken in the first place.

The Rosenthals, owners of Rosenthal Retirement Planning, a Fort Worth-based retirement advisory firm with assets under management totaling $400 million, have seen most scenarios play out in front of their eyes when dealing with clients who have retired early and choose to take a distribution through a 72(t). Julie is a financial professional who was a tax and estate planning attorney prior to joining her husband’s practice. Burk’s business card puts CFP, CFS and ChFC after his name. Together they have over 15 years’ experience counseling clients on all aspects of personal finance.

A provision under the Internal Revenue Service Rule 72(t) allows investors to take a penalty-free early withdrawal from a retirement account. The rule requires the account owner to take substantially equal periodic payments for a period of five years or until age 59 1/2 , whichever is longer. While a 72(t) distribution plan allows for tapping into retirement savings before 59 1/2 , when there is otherwise a 10 percent penalty on early withdrawal, the withdrawals are still taxed at the borrower’s income tax rate.

Stick to ItAccording to the Rosenthals, a 72(t) distribution can be a great way to provide income for an individual taking early retirement. They warn, however, that investors should be committed to the program and avoid modifying it once it has begun, unless they are prepared to utilize Revenue Ruling 2002-62, which allows for a one-time adjustment without being considered a modification (therefore no penalties would apply to the situation).

“There is a misconception among many consumers and a few financial advisors regarding 72(t) regulations,” says Burk. “Even my view of how 72(t) should be utilized has changed over the past few years. I now believe that a 72(t) distribution is a way to retire early and take a conservative income. Most importantly, people must be prepared to make adjustments to their financial plan at age 59 1/2 .”

Burk’s view has changed in light of the way the stock market performed in the early part of this decade. “The danger for clients is that if the market is not performing well and the client is withdrawing fixed payments required by 72(t), the account is drawing down at a rate that outpaces its appreciation.” The drawback to a 72(t) distribution, according to Burk, is that without proper planning, retirement accounts could be depleted well before a person dies.

A Last ResortWhile it is always an option, modifying a distribution schedule rarely makes financial sense, in this view. “Busting a 72(t) should be one of a client’s last resorts — especially if the goal is to take a larger distribution,” says Julie. “We try to convince clients to first look at the long-term effects of busting their 72(t). Then we try to convince them to go back to work, if only for the short term, to avoid busting their 72(t) as a means of solving their current financial crisis.”

According to the Rosenthals, a good advisor who is serving as a fiduciary for a client is cognizant of what the market is doing versus what the client is withdrawing because a 72(t) is an IRS provision meant to allow for an early retirement, rather than one at 59 1/2 . Some financial professionals calculate a 72(t) distribution not with the clients’ long-term best interest in mind, but rather with an eye toward making the client happiest with a big distribution check for the short term, ignoring the fact that at 59 1/2 , when clients reach traditional retirement age, there may be little left of their nest eggs, depending on the rate of distribution and the performance of the stock market.

“I once lost a potential client because of the difference in the way I and the professional who ultimately won the business think about the client and their financial future,” sighs Burk. “I was told ‘you are only going to pay me between 4 percent and 6 percent and this other guy is going to pay me 12 percent.’ I was absolutely floored that this potential client had completely misunderstood the premise behind a 72(t) and thought that the other advisor was somehow guaranteeing the client a rate of return. In fact, there is no way that kind of withdrawal can be taken without serious consequences down the road.”

Not all 72(t) stories are bad ones. Julie remembers a client who had retired early from his job after 35 years of service at a utility company. He had a $375,000 nest egg but came to the Rosenthals in financial dire straits. He had $50,000 in credit card debt, which he and his wife had somehow racked up in their carefree early retirement delight. His knee-jerk reaction was to bust his 72(t).

The client was unwilling to go back to work as a means of solving his financial issues. After being shown that in order to have $50,000 to pay off his credit card debt he would need to take an $80,000 distribution, the client instead used a debt consolidation strategy to eliminate his debt. The client was able to pay down his debt before he reached 59 1/2 to a manageable $15,000. That allowed his retirement nest egg to continue to grow.

“While the above scenarios show the downside of a 72(t) distribution plan, they tend to be pretty rare. In most situations, investors can use 72(t) distributions to supplement their income prior to becoming eligible for either a deferred vested pension and/or Social Security benefits,” Burk says.

Marie Swift is the president of Impact Communications, a marketing and communications firm for independent advisors; see www.impactcommunications.org.