Avoiding Penalties for Early Retirement

Distributions from an IRA prior to age 59 ½ may be subject to a 10% IRS penalty in addition to ordinary income taxes. Under Internal Revenue Code 72(t), there are certain exceptions that will allow the 10% penalty to be waived by the IRS, such as death, disability, medical expenses greater than 7.5% AGI, Substantially Equal Periodic Payments, etc.

The Substantially Equal Periodic Payments portion of the IRS Code 72(t) is of particular importance to early retirees, because it allows a person to access their IRA funds prior to reaching age 59 ½ without paying an additional 10% penalty. There are certain conditions that must be met, however, to take advantage of this exception. The conditions include:

• Payments have to be based on the IRA owner’s life expectancy or joint life expectancy of the IRA owner and his/her beneficiary
  
• Payments must be substantially equal periodic payments
  
• Payments must be calculated using an interest rate no more than 120% of the applicable federal mid-term rate for either of the two months immediately preceding the month the distribution begins


• The IRA owner must continue the payments for the later of five years or until age 59 ½, whichever is longer

The three methods of calculating the 72(t) SEPP payments are:

Amortization method – think of this method the way you would your mortgage. The account balance is “amortized” over the IRA owner’s life expectancy or the IRA owner and designated beneficiary’s joint life expectancy. The interest rate used cannot exceed 120% of the applicable federal mid-term rate.

Annuity factor method – The account balance is divided by an “annuity” factor. The annuity factor can be derived by using up to 120% of the applicable federal mid-term rate, the attained age of the IRA owner and the
annuity table in Revenue Ruling 2002-62.

Required Minimum Distribution
method – The account balance is divided by the IRA owner’s life expectancy (use the IRS life expectancy table, either the single or uniform table). Just remember whichever table used must continue to be used for all subsequent years.

The annuity factor method often results in the highest income payment and the RMD method usually results in the lowest income payment.