Fortune 500 Employees: How 72(t) Avoids the 10% Penalty

How Can Fortune 500 Employees Avoid Penalties?

As you approach retirement, it's essential for Fortune 500 employees to explore options like Rule 72(t) to manage their IRA distributions strategically. An interesting aspect of Rule 72(t) is that it allows for the use of different distribution methods, rendering possible the creation of a retirement strategy specifically catered to your needs. 72(t) payments are also referred to as "substantially equal periodic payments." These payments are advantageous because of their exemption from the 10% early distribution penalty that typically applies to withdrawals made before age 59 1/2. You can withdraw them at any time from an IRA, but only after departing Fortune 500 from a workplace plan.

Let's begin with the disadvantages of 72(t) payments.

1. First, they must remain in place for a minimum of five years or until age 59 and a half, whichever occurs first. This implies that a 45-year-old IRA owner must continue making contributions for nearly 15 years.

2. Second, if the payments are modified prior to the end of the 5-year/age 59 1/2 period, you will incur a 10% penalty (plus interest) on all payments made prior to age 59 1/2. The modification will typically occur if you change the payment schedule (e.g., stop payments), the account balance from which payments are being made (e.g., a rollover), or the method used to calculate the payment schedule (with the exception of a one-time switch to the RMD method – see below).

Fortune 500 employees have three permissible options for calculating 72(t) payments:

1. RMD stands for required minimum distribution. Payments are calculated as RMDs over a lifetime. Consequently, they vary annually. The RMD method typically yields the lowest compensation of the three options. Once you begin using the RMD method, you cannot abandon it.

2. The method of fixed amortization. The installments are calculated similarly to fixed-rate mortgage payments. After using this approach for at least one year, there is no penalty for switching to the RMD method.

3. The method of fixed annuitization. Calculating payments involves dividing the account balance by an annuity factor. As with the amortization technique, they remain constant, and you can switch to the RMD method following the first year.

Section 72(t)(4)(A) of the Internal Revenue Code mandates that Fortune 500 employees must continue taking 72(t) distributions from their IRAs for 5 years or until they attain age 59 1/2 (with the exception of death or disability).

For instance, an individual working for Fortune 500 beginning 72(t) distributions at age 57 will 'only' have to maintain their distribution schedule for 5 years (because even though they would turn 59 1/2 after 2 1/2 years, the payment schedule must be kept for a minimum of 5 years), whereas a taxpayer beginning 72(t) distributions at age 40 would have to maintain the schedule for nearly two decades (since they would not turn 59 1/2 for another 19 1/2 years).

Once Fortune 500 employees begin receiving 72(t) payments, the penalties for altering or cancelling the payment schedule can be severe. Section 72(t)(4)(A) of the Internal Revenue Code states that if a taxpayer modifies their 72(t)-payment schedule before the end of the 5-year period or reaching age 59 1/2 (whichever comes later), the 10% early distribution penalty will be applied retroactively to all pre-tax distributions taken prior to age 59 1/2.

In addition, the IRS will retroactively apply interest to these amounts in these circumstances, treating the penalty as if it had been applied at the time of distribution but not yet paid.

Penalties Are Steep

Example 1: In 2010, at the age of 44, Mark established a 72(t) payment schedule for his Traditional IRA distributions. According to the 72(t) regulations, the schedule was to conclude in 2025, when Mark turns 59 and 1/2.

In 2021, at age 55, Mark entirely forgot to take his annual 72(t) distribution, thus 'breaking' the schedule, despite having taken distributions on schedule for a decade.

Due to the error, the 10% penalty will be applied retroactively to all of Marks' prior distributions, beginning with the first in 2010 and ending with the most recent in 2021.

In addition, interest will be applied to the 10% penalty amount for 2010 as if it had been owed since 2010 but not yet paid, resulting in 10 years of interest being applied to the 2010 payment. Similarly, interest will be applied to the 2011 10% penalty amount as if it had been owed since 2011 but not yet paid, resulting in nine years of interest being applied to the 2011 payment. And so forth.

The second and third methods necessitate the use of an interest rate when calculating the amortization or annuity factor. In the past, the IRS has stated that this factor cannot exceed 120% of the Federal mid-term rate in effect for either of the two months immediately preceding the beginning of the 72(t) payments. For several years, the Federal mid-term has been historically low. 120% of the Federal mid-term rate for February 2022 is only 1.69 percent.

72(t) Changes

The timing of 72(t) payments must be accurate for Fortune 500 employees to avoid early distribution penalties, as well as the correct calculation of the payment amount(s). Intriguingly, the Internal Revenue Code provides little guidance on how to properly calculate 72(t) distributions, other than stating that they must be "substantially equal" (in fact, the above excerpt from IRC Section 72(t)(2)(iv) is the totality of the Internal Revenue Code's guidance). Consequently, the vast majority of the guidance we do have on how to calculate 72(t) payments comes from other sources, such as IRS Notices.

The IRS issued Notice 2022-6 on January 18, 2022, stating that 72(t) payment schedules commencing in 2022 or later may use an interest rate as high as 5%. (And if 120% of the Federal mid-term rate increases above 5%, you can use the 120% rate.) This is excellent news for Fortune 500 employees, as the greater the interest rate, the greater the payments. This modification enables you to make larger payments from the same IRA balance.

Note: You cannot alter the interest rate for a series of 72(t) payments that have already been established.

In addition, the 5% rate cap applies to all payment series commencing in 2022 or later.

This is significant for Fortune 500 employees contemplating a 72(t) schedule because it substantially increases the maximum interest rate that can be used (and, consequently, the number of potential penalty-free distributions that can be made prior to age 59 1/2).

Consider that the rate for October 2022 was 3.90 percent. Prior to the new guidance from Notice 2022-6, taxpayers beginning 72(t) schedules in November 2022 with distributions calculated using either the amortization or annuitization methods were limited to using a maximum interest rate of 3.90 percent (the higher rate from the two months preceding the month the schedule began).

Jennifer, age 50, has recently decided to use 72(t) payments as a means to access her IRA funds without incurring an early distribution penalty. She plans to make a series of annual distributions beginning in March 2022. Jennifer's IRA balance is currently $1 million.

Jennifer is unaware of the new rules specified by Notice 2022-6 and calculates her maximum annual 72(t) payment using the 3,90% maximum rate applicable prior to the issuance of Notice 2022-6.

After calculating her potential maximum annual 72(t) distribution using each of the three methods and available life expectancy statistics, Isabelle determines that the amortization method yields the highest possible annual 72(t) distribution at 3.90 percent.

Nonetheless, as a result of Notice 2022-6, retirees can now use a 5% interest rate instead, resulting in a substantially larger 72(t) distribution from the same account balance than was possible under the prior rule.

Doug, Jennifer's coworker, has recently decided to utilize 72(t) payments to gain penalty-free access to his IRA funds. Likewise, his current IRA balance is $1 million.

Doug's advisor, thankfully, is aware of the new 5% interest rate cap for 72(t) and applies it to calculate Doug's maximum annual 72(t) payment beginning in November 2022.

Doug determines, after calculating her potential maximum annual 72(t) distribution using each of the three methods and available life expectancy tables, that the amortization method yields the highest possible annual 72(t) distribution of $60,312.23, a substantial increase over the 3.90 percent under the old rules.

Common 72(t) Questions

When can Fortune 500 workers begin 72(t)?

Fortune 500 employees may begin taking 72(t) distributions from their IRA at any age.

How long must Fortune 500 workers maintain the withdrawals?

The payments must continue for a minimum of five years or until you reach age 59 and a half, whichever is lengthier.

How frequently must Fortune 500 employees make withdrawals?

Fortune 500 employees are required to accept the payments on an annual basis.

Can Fortune 500 workers initiate 72(t) payments from their 401(k)?

The 72(t)-payment plan is applicable only to the IRA or IRAs from which the initial payment was calculated. Depending on your requirements, you can split your IRA into two IRAs prior to establishing a 72(t)-payment plan. One IRA can be used to calculate and withdraw 72(t) payments, while the other remains available for non-72(t) purposes.

How do Fortune 500 employees determine payment amounts?

Three methods have been approved by the IRS for calculating 72(t) payments. The required minimum distribution (RMD) method, the amortization method, and the annuity factor method are these methods. The RMD method will initially generate lesser payments than the other two methods. Although other methods of calculating the payments are not strictly prohibited, it would be exceedingly risky to use a method that has not been approved by the IRS. Generally, you should consult a tax or financial advisor when calculating your 72(t) payments.

After beginning 72(t), can Fortune 500 employees alter their method?

You can transition from the amortization or annuity factor method to the RMD method. This is a one-time, irreversible change, and the RMD method must be used for the remainder of the schedule.

Can Fortune 500 workers cancel their 72(t) payments?

If you do not adhere to your 72(t)-payment plan or if you modify the payments, the 10% penalty exemption will no longer apply. Even worse news: the 10% penalty will be reinstated retroactively for all distributions taken prior to age 59 1/2.

Can Fortune 500 employees take 72(t) additional withdrawals in the event of an emergency?

A supplemental withdrawal is regarded as a change to the payment schedule. Any change in the account balance that is not the result of regular gains and losses or 72(t) distributions will also be regarded as a modification and will trigger the 10% penalty. This indicates that neither rollovers nor contributions can be used to fund an IRA. You cannot convert or rollover your 72(t) payments.

Conclusion

In the realm of financial strategies, Fortune 500 employees nearing retirement can approach the 72(t) rule with the finesse of a seasoned conductor leading an orchestra. Similar to how a conductor carefully orchestrates the harmony among musicians, understanding and implementing the provisions of the 72(t) rule requires meticulous planning and coordination. By conducting their financial moves with precision, these employees can navigate the complexities of early withdrawals from their retirement accounts, ensuring a harmonious balance between accessing funds and avoiding penalties. Just as a conductor guides a symphony to create a masterpiece, a well-executed 72(t) strategy can lead to a harmonious and secure retirement journey.