Although IRAs are intended to be long-term retirement savings vehicles (like employer-sponsored retirement plans), unexpected financial needs can arise, and your clients may find themselves wondering if they should tap into their accounts. Typically, IRA owners who distribute assets from their account before age 59½ are subject to a 10-percent early withdrawal penalty on the distribution amount. But with 72(t) plans, also known as a substantially equal periodic payment plans, IRA owners can distribute assets before age 59½ and avoid that penalty (though normal income tax rates would still generally apply).

Too good to be true? Maybe so, as there are a few tight restrictions with these payment plans that you would be wise to review and share with your clients.

The Plan Duration

The IRS requires 72(t) plans to remain in place for either five years or until the IRA owner reaches age 59½—whichever period is longer. For those who are a year or two away from age 59½, they may find that having access to their IRA funds penalty free doesn’t outweigh the downside of maintaining the plan for the next five years. And someone who has just turned 50 would have to maintain the plan for almost 10 years.

The plan generally “locks” the IRA so only the calculated payment amounts can be made, which makes it difficult to be prepared for any additional unexpected financial needs in the future. Aside from fulfilling the appropriate duration of the plan, it can only be stopped due to the IRA owner’s disability, death, divorce, or depletion of the account.

The Distribution Calculations

Often, your clients may need a specific amount from their IRA to fill an income gap or a financial need. They can’t simply decide how much to withdraw from their IRA under a 72(t) plan, however. These plans use one of three methods—amortization, annuitization, and required minimum distribution (RMD)—to calculate the amount available to withdraw.  Each method, which depends on a number of factors, such as the client’s age and account balance, yields a different result.

With the amortization and annuitization methods, the annual amount will be fixed for the duration of the plan. With the RMD method, the amount will change each year, based on an annual calculation using the December 31 account balance and the IRA owner’s IRS life expectancy factor. The IRS does allow a one-time change to the calculation method, but even this is limited to switching from either amortization or annuitization to the RMD method.

The Lack of Wiggle Room

Once a 72(t) plan begins on an IRA, the account balance cannot be modified. Transactions such as rollovers or transfers into or out of the account are generally not allowed, and aside from the calculated amounts that must be distributed each year, additional distributions cannot be made. The IRA owner also cannot take less than the calculated amount. It is possible, however, to execute a full trustee-to-trustee transfer if you need to move the account to another custodian.

The Consequences for Breaking the Rules

What happens when any of the rules aren’t followed? The IRS will consider the plan “busted” and will impose the 10-percent early withdrawal penalty on all current and past distributions taken since the inception of the plan. This can prove to a be a costly mistake for IRA owners, especially if they had been running their plan for several years already.

Say a client established a 72(t) plan on an IRA in January 2015 and was required to maintain the plan for five years while taking $20,000 per year. If the client distributed only $19,000 in January 2019, the plan would be considered busted, and the 10-percent early withdrawal penalty would apply to all distributions from the IRA going back to January 2015. For a client who chose this option due to a hardship, this is a terrible outcome.

The 72(t): A Last Resort

Although a 72(t) plan is a viable solution to provide clients with a string of income during hard times, diligence in its execution is of the utmost importance. This will help ensure that the client isn’t subject to any premature distribution penalties.

This strategy should be used only as a last resort, however, since depleting IRA assets before retirement can have a significant impact on retirement income. Other options to review with your client include tapping into a bank savings account, applying for a personal loan, or seeing if the client qualifies for any IRS premature penalty exceptions.

What do you suggest when your clients are considering withdrawing assets from their IRA before they reach age 59½? Do you have clients who have chosen to use a 72(t) plan despite the risks? Please comment below!