What is the Rule of 72(t)?

Contributing to a workplace or individual retirement account can have numerous benefits. Among these are the ability to put money away on a tax-deferred basis, which can allow your savings to potentially grow tax-free until you reach retirement age. But life often throws us curveballs, and people may need to access their savings sooner than expected.

One way to potentially withdraw funds before retirement age without a penalty is through something called the Rule of 72(t), which allows for early withdrawals if they are taken in what’s known as a series of substantially equal periodic payments, or SoSEPP, also referred to as a SEPP plan.

While the payments are technically withdrawals from your retirement account, the IRS calls them payments to distinguish them from early withdrawals that may have a penalty. Money from a SEPP plan must be received over the course of 5 years, or until you’ve reached age 59½, whichever is longer.

Here are more details about how the Rule of 72(t) works.

What is the Rule of 72(t)?

The Rule of 72(t) is the part of the US tax code governing all withdrawals from workplace and individual retirement accounts, regardless of whether these withdrawals happen at retirement age or before. It also outlines an exception for people who wish to withdraw funds from an individual retirement account (IRA) or workplace retirement account such as a 401(k) prior to age 59½. Such people can avoid a 10% penalty on withdrawals from qualified accounts provided they withdraw funds using a SEPP plan. (You can find the precise rules at IRS.gov.)

What is a SEPP plan?

A SEPP plan is a way to withdraw funds from a retirement account prior to age 59½ using an IRS-approved method to calculate the withdrawal, or payment. Withdrawals can be done annually, monthly, or quarterly, as long as they are consistent and for a period of at least 5 years, or until the account owner reaches age 59½, or the account is depleted. Each payment must follow the same calculation, which with a few exceptions can’t be changed after you start taking distributions.

Note: A SEPP plan applies to a single account and can’t be used for combined balances of multiple accounts. If you plan to withdraw from more than one account, you must set up a separate SEPP plan for each eligible account.

How does the Rule of 72(t)/SEPP work?

To use the Rule of 72(t), you must first calculate the amount of your SEPP. Generally, there are 3 methods approved by the IRS (see below), though it is possible to use others, according to the IRS. The payments must continue for at least 5 years, or until you turn age 59½, whichever is longer.

If you follow the SEPP schedule, you won’t owe the 10% early withdrawal penalty on the money taken out. However, you still owe income tax. Good to know: You can’t change or stop the SEPP once you’ve started it, otherwise you’ll owe a penalty. If you make any adjustments to your scheduled withdrawals before reaching the deadline, you would owe a recapture tax penalty equal to 10% of the qualified funds already withdrawn. Exceptions to this penalty are death or disability of the account owner, and a one-time change to the RMD method. There are also exceptions for qualified public safety employees or if your account balance goes to $0.

Are distributions from a SEPP plan taxable?

Yes, distributions from a SEPP plan are taxable as ordinary income to the same extent that any other withdrawals from your account would be, including cost basis calculations, so it’s important to consider the tax implications of such a plan and advisable to speak with a financial professional to plan accordingly.

How to calculate Rule of 72(t)/SEPP

You can choose among 3 preapproved IRS distribution methods for a SEPP plan. All 3 use one of the IRS life expectancy and mortality tables to make their SEPP calculation. Two of the methods use a combination of a life expectancy or mortality tables plus an interest rate to determine the payment amount. Note: Your filing status will determine which table you use and will also impact the amount of your distribution.

If you choose a method that requires an interest rate, you must generally choose a rate that is the greater of 5% or 120% of the federal mid-term rate, an IRS rate based on prevailing Treasury rates, although a lower rate may be possible. Lower interest rates would mean lower payments, generally, and each method would also result in a different payment amount that could affect your income planning.

1. The required minimum distribution (RMD) method

The RMD method relies solely on distributions determined by IRS lifetime expectancy tables used to determine RMDs. Unlike other distribution methods, it doesn’t use an interest rate to make its distribution calculation. Distributions may be smaller since the RMD method divides your account balance by your life expectancy factor, which is higher at a younger age. It may make sense to use the RMD method if you need a smaller amount of extra income and you would like to keep more in the retirement accounts for more tax-deferred growth over time.

Good to know: The RMD withdrawal will change each year based on your account balance at the end of the prior year and your age. Depending on portfolio performance, you may wind up withdrawing more in years your balance increases and less in years your balance decreases. It will also be calculated separately for each retirement account.

2. The fixed amortization method

The amortization method determines distributions by dividing your retirement account balance by your life expectancy when you start the SEPP plan, and then applies an interest rate to the balance. It calculates payments based on your life expectancy determined by the IRS using either the uniform lifetime table, the single life expectancy table, or the joint life expectancy table. While amortized distribution amounts remain the same throughout the payout period, this method may lead to larger payments and could make sense if you need more cash as distributions can be larger than with other withdrawal methods.

3. The fixed annuitization method

The annuitization method sets fixed payments by dividing your account balance by an annuity factor, which is determined through an IRS calculation based on the mortality tables—which is different from the life-expectancy tables above—and your chosen interest rate. This method typically leads to payments bigger than the RMD method, but smaller than the amortization method. Like the amortization method, the payments don’t change over time. Good to know: A fixed annuity from an insurer, which makes periodic payments for your life or based on your life expectancy, may satisfy the requirements and ease your calculation burden. Consult a tax professional.

Rule of 72(t)/SEPP calculator

Rule of 72(t) calculations can be complex, and you should consider consulting a tax or financial professional to help you calculate any withdrawals. An online 72(t) calculator can also help you run the numbers and determine which might make sense. For example, using Fidelity’s 72(t) calculator, here is what a SEPP would look like for a hypothetical single 55-year-old who has $500,000 in a retirement account. The 72(t) calculator shows the following results using a 4% interest rate and single life expectancy.

The table shows the allowable annual 72(t) withdrawal based on 3 IRS-approved methods. Outside of regular market activity, an IRS balance can’t be changed. Funds cannot be added to the account and additional distributions that exceed the 72(t) withdrawal amount are not allowed. The calculation is hypothetical, for illustrative purposes only, and is dependent on the information provided. The calculation relies on a number of simplifying assumptions, and the results may vary based on a user’s actual situation. As tax and other laws change from time to time, there's no guarantee that the information used in this calculation is accurate or up to date. This calculation should not be used for or considered as investment or legal advice.

The calculation shows withdrawal amounts that meet IRS requirements by withdrawal method.

Advantages of Rule of 72(t)/SEPP

Avoids the 10% early withdrawal penalty. The main advantage of the Rule of 72(t)/SEPP is that you can tap into your retirement savings early without the 10% penalty. That penalty adds up quickly. If you take $30,000 a year from your retirement plan, you avoid $3,000 of annual tax penalties using this system versus penalized early withdrawals.

Creates predictable income. By design, the Rule of 72(t)/SEPP withdrawals create an ongoing income stream. That can work like a replacement paycheck, helping you budget.

Offers some customization. You pick the IRS-approved SEPP and the interest rate, giving you some flexibility to decide on how much comes out of your retirement plan early under the Rule of 72(t). The income can be paid to you on a monthly, quarterly, or annual basis.

Disadvantages of 72(t)/SEPP

Depletes your retirement savings. Taking money out of your retirement savings early means you’ll have less left over for later life, potentially causing you to run out. You must carefully budget and plan before tapping into your retirement accounts in your 50s or earlier.

Can’t be changed or stopped. Once you start the SEPP plan, payments must continue as scheduled. If you stop or alter them, you would generally owe a penalty that would be retroactive on all the funds withdrawn. There are a few exceptions. You also can’t deposit money back into your retirement plan while distributions from the SEPP plan are ongoing.

Doesn’t allow additional withdrawals. You cannot withdraw more than the SEPP amount from your retirement account. Otherwise, the 10% penalty applies. So it’s important to understand what your income needs are while you’re setting up the SEPP plan.

Alternatives to the Rule of 72(t)/SEPP

If you need money from your retirement plans, there are other ways to withdraw without the penalty. Be sure to consider these options before locking in the SEPP plan.

Early withdrawal penalty exceptions. IRAs and 401(k)s allow penalty-free early withdrawals in specific situations, like higher education expenses, disability, and health insurance when unemployed. Check whether any of these apply. If so, you could withdraw only what you need penalty-free without committing to a SEPP plan.

401(k) loans. If you only need money for a short time, check whether your 401(k) allows you to take a loan. If so, you could borrow up to 50% of your vested balance or $50,000, whichever is less. A 401(k) loan would only be applicable for current employees and would not work for income coverage for someone already in retirement. You wouldn’t owe income tax or the 10% penalty for the borrowed funds. However, you would owe interest to the 401(k) plan until you pay back the money. Good to know: If you don’t pay the loan back, the outstanding loan amount is considered a "deemed distribution" from your retirement account. This means it is treated as a withdrawal for tax purposes and added to your gross income for the year. You must pay federal and state income taxes on the amount of the defaulted loan.

401(k) withdrawals under the Rule of 55. 401(k)s and other workplace plans may offer another way to withdraw your money early. If you are turning age 55 or older in the year you separate from your company, you can start taking retirement withdrawals from your plan. The 10% penalty does not apply. This rule does not apply to withdrawals taken from an IRA at age 55.

Who might the Rule of 72(t)/SEPP make sense for?

The Rule of 72(t)/SEPP could be good for someone who retires early, doesn’t expect to work again, has enough retirement savings for their long-term goals, is in poor health, or needs extra income to pay for essential expenses.

This rule can also be helpful for people who need to tap their retirement savings for a certain period before they plan to retire; for example, if they need an income bridge before pension or Social Security benefits begin. Given the inflexibility of this rule, however, it’s important to research carefully before starting. Make sure to compare your other options before committing to a SEPP plan. Consult a tax advisor about your personal situation.

Using a Rule of 72(t)/SEPP plan can be complicated and you should consider working with a tax professional who can help you understand if a SEPP plan is right for you. A financial advisor can help you determine whether the Rule of 72(t)/SEPP makes sense for you and, if so, set up the withdrawals to meet the IRS rules.