Some of your clients who began saving for retirement early in life can now consider themselves ahead of the game. This is quite an achievement, as setting aside part of your paycheck for your 60s and 70s instead of splurging on an overdue vacation or your dream car can be tough. Perhaps they have realized that the benefits of saving early can often outweigh the sacrifices. Still, some savers may ask themselves, "What if something happens along the way and I need access to the money immediately?"
Fortunately, the IRS provides a solution that may be appropriate for certain clients: a series of substantially equal periodic payments (SEPPs), also known as a 72(t) plan. These plans are intended for IRA owners who are under age 59½ but do not qualify for the IRA premature distribution exceptions listed in IRS Publication 590-B.
Do you have clients who might be interested in this alternative? If so, what questions about 72(t) plans should they be asking? Keep in mind that the IRS has strict guidelines when it comes to their use, and this option should be used only as a last resort. Depleting IRA funds before retirement can potentially have a serious effect on retirement income once an individual stops working. Your clients will need guidance, and with this in mind, I've compiled six questions (and answers) to consider when discussing 72(t) plans with your clients.
IRAs and the IRS
As you know, IRAs aren't like bank accounts. Your clients can't deposit and withdraw limitless amounts of money. In fact, if a client does distribute money from his or her IRA before reaching age 59½, the IRS will apply a 10-percent early distribution tax to the amount. There are exceptions to this penalty, including:
- Qualified higher education expenses
- First home purchase
- Unreimbursed medical expenses
But what if your client doesn't qualify for these exceptions? That's where the 72(t) plan may come into play. So, what do your clients need to know?
1) What Is a 72(t) Plan?
A 72(t) plan is a series of equal payments based on a client's life expectancy. Under Section 72(t) of the Internal Revenue Code, IRA owners under age 59½ may distribute funds from the IRA on a regular basis, without facing the 10-percent early withdrawal penalty tax.
The plan duration must be either five years or until the client reaches age 59½, whichever time period is longer (with some exceptions). For example:
- If a client begins a 72(t) plan at age 50, the plan must continue until the client reaches age 59½, a total of nine and a half years.
- If a client begins a 72(t) plan at age 57, the plan must continue for five years (when the client is age 62).
2) Are SEPPs for Everyone?
The IRS has set strict guidelines for establishing SEPPs. The circumstances surrounding a client's distribution strategy must be reasonable and follow 72(t) rules, some of which are outlined here. In addition, FINRA has expressed concerns about financial professionals promoting SEPPs to clients as a gateway to early retirement. Inducing customers to take early distributions and to invest the proceeds in variable annuities, Class B or Class C mutual fund shares, or exchange-traded funds to pay for early retirement can involve significant risk.
3) How Is the Payment Amount Determined?
There are three methods that can be used to determine the payment amount a client can take. Each is based on the client's life expectancy and the IRA's balance:
- Required minimum distribution (RMD)
- Fixed amortization
- Fixed annuitization
Which method is best? It depends on the client's unique circumstances. The client must determine if he or she is looking to distribute the greatest amount or the lowest amount possible, as each method yields a different result. Clients should consult a tax advisor to determine which method is best for them.
- With the RMD method, the payment amount is recalculated each year.
- With the fixed amortization and fixed annuitization methods, the amount remains the same until the plan is no longer in effect.
Can you change methods? If the original calculation was based on either the fixed amortization or fixed annuitization method, the client may change it to the RMD method:
- This may only be done once throughout the plan's duration.
- This change cannot be reversed.
- A client cannot have a calculation based on the RMD method and then change it to one of the other two methods.
4) Can Changes Be Made to an IRA While a 72(t) Plan Is in Effect?
The simple answer is no. While a 72(t) plan is in effect on an IRA, the value of the account cannot be modified in any way. Your client cannot:
- Contribute to the account
- Distribute more or less than the exact amount of the SEPP calculation
- Roll over, journal, or transfer any funds into or out of the IRA
A trustee-to-trustee transfer of the entire IRA to an IRA held at another institution is allowed. But no other assets can be combined with the 72(t) assets. Exceptions to these rules include interruptions of the plan due to the IRA owner's:
- Account depletion
Keep in mind, the IRA in question is treated separately from any other IRA the client may own. Although a client with a 72(t) plan on one IRA is restricted from taking any of the actions described above in that IRA, he or she is free to do so in another IRA where a 72(t) plan is not in effect.
5) Is There a Penalty for Breaking the Rules?
A violation of any 72(t) plan rule will "bust" or "break" the plan: A retroactive 10-percent premature tax penalty will be incurred on any current or previous distributions from the account during the existence of the plan, including any interest for the period of delay. For example:
- If your client has been taking monthly 72(t) payments for three years and transfers money into the IRA in the fourth year, the plan is considered busted or broken.
- The IRS will impose the 10-percent premature penalty on each and every monthly distribution taken from the IRA in the last three years.
6) How Will a Client Know the 72(t) Plan Duration Has Been Satisfied?
As previously mentioned, the duration of a 72(t) plan is the longer of five years or until the client reaches age 59½. For example:
- An IRA owner who began payments at age 56 on December 1, 2014, cannot alter his distribution amount or IRA until December 1, 2019, even though he will have taken his fifth and final annual payment on December 1, 2018.
- An IRA owner who began taking payments at age 53 on December 1, 2014, and turns 59½ on July 1, 2021, will be able to modify her plan or IRA on July 1, 2021.
There is no requirement to notify the IRS once a 72(t) plan has been satisfied. After plan completion, the client can manage the IRA as normal. Clients should be sure to keep accurate and detailed records of:
- Start date
- Calculation method
- Other information concerning when the plan will end
A Complex Solution
The guidelines governing 72(t) plans are complex. If you're interested in learning more, visit the IRS FAQ page. Also, clients may consider consulting a tax advisor prior to establishing a 72(t) plan. When you take the proper steps to educate your clients on the rules and tax implications before establishing a 72(t) plan, they will better understand the complexities of this retirement income option.
Have you talked with your clients about this option? Do questions about 72(t) plans tend to come up in your discussions? Tell us below!