Potential Pitfalls of 72 (t) – Early IRA Withdrawals
The following is a breakdown of some of the basics of the 72(t) program and things to consider before doing a 72(t).
Discussing plans for retirement is a daunting task. Now throw in a reference to 72(t) and most people have no idea what you are talking about. 72(t) has the potential, if done wrong, to cost a hefty sum in penalties and fees and to leave you worse off in retirement than if you had simply waited to start withdrawing from your IRA. However, some financial advisors encourage their clients to use 72(t) as a means of taking money from their retirement fund early. To understand why a financial advisor may instruct someone to take advantage of this high-risk rule we must first understand how retirement accounts work.
An Individual Retirement Account (IRA) is an account that allows you to save for retirement either with after-tax earnings or on a tax-deferred basis. Different IRAs offer different tax benefits for your overall savings. With a Traditional IRA, you invest your earnings in a tax-deferred account until you are ready to withdraw them in retirement.
For example, if you wish to invest in a 401(k), the money invested will come out of your paycheck before taxes and remain untaxed until you withdraw them in retirement. On the other hand, a Roth IRA allows you to invest the earnings you have already paid taxes on. This money may then grow tax-free, with tax-free withdrawals in retirement. Whether you choose a Traditional or Roth IRA, their tax benefits allow your savings to potentially grow, or compound, more quickly than in a taxable account.
A problem with setting up an IRA is that if you take your money out of it before turning 59.5, you have to pay a 10% early withdrawal penalty. However, the IRA allows for an exception to avoid the penalty by taking 72(t) “substantially equal periodic payments.” With 72(t) substantially equal periodic payments, the Internal Revenue Code permits distributions prior to age 59.5 based on one of three IRS-approved life expectancy calculations. This means that you must continue to take funds from your IRA for 5 years or until you reach age 59.5, whichever comes later. For example, if you start taking your payments at the age of 52, then you must do so for 8 years. Someone who starts at 57, must do so till the age of 62. Once you have withdrawn payments for 5 years and you have reached age 59.5, you can discontinue the payments if you so desire.
While the 72(t) exception sounds like an ideal solution to waiting until you are older to start withdrawing from your IRA (and to therefore allow you to retire early), it has its drawbacks. The periodic payments you are required to withdraw are still taxed at your income rate.
Also, once 72(t) payments start they cannot be stopped or modified for any reason. If payments are modified other than due to the death or disability of the IRA owner, a 10% federal income tax penalty plus interest will be retroactively applied to the payments beginning with the first year of your distributions. This means that if you are in year 4 of taking 72(t) payments and you violate the guidelines of 72(t), you will have to pay a 10% tax penalty and interest on the entire amount you have withdrawn over the first 3 years and not just on the amount you violated in year 4. This retroactive penalty can be disastrous for individuals already in a tough financial position.
Risks of Early Withdrawal in your IRA
Even with these risks, some financial advisors recommend 72(t) to clients who want to take money from their IRA early. This can be bad advice. For example, say you do the 72(t) life-expectancy calculation while the market is doing well and you begin withdrawing interest funds from your IRA. Should the market suddenly experience a downturn, you are now stuck withdrawing at your initial rate.
These forced withdrawals could cause you to wipe out your interest, whittle away at your principal, and ultimately deplete your retirement fund. You may also be forced to sell your investments in order to generate cash to get your payments out. Meanwhile, this activity often generates high fees and commissions for your financial advisor, reducing your account even further.
At the end of the day, your IRA is your nest egg. It’s a long-term investment in your future and it should be treated as such. While unforeseen circumstances happen in life, 72(t) should not be your only option in addressing your financial concerns or desire to retire early.
If you believe your financial advisor took advantage of you by recommending a 72(t) and you suffered losses, please call The White Law Group at (888) 637-5510 for a free consultation.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm dedicated to the representation of investors in FINRA arbitration claims against brokerage firms throughout the United States.
To learn more about The White Law Group, visit www.WhiteSecuritiesLaw.com.