72(t) Distributions: Impact on retirement fund balances
The Internal Revenue Code section 72(t) and 72(q) allows for penalty free early withdrawals from retirement accounts. The IRS limits how much can be withdrawn by assuming any future earnings will be at most 120% of the Federal Mid-Term. This conservative approach can help assure that you will not prematurely deplete your retirement account. However, if you have a higher rate of return your account can actually grow, even with your distributions. On the other hand, if you suffer losses your account balance may end up shrinking faster than you might expect. This calculator is designed to examine the affects of 72(t)/(q) distributions on your retirement plan balance.
- Distribution interest rate
This is any rate less than or equal to 120% of the Federal Mid-Term
rate for either of the two months immediately preceding the month in
which the distribution begins.
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For Oct. 2010, 120% of the Federal Mid-Term rate is 2.07%.
It is important to note that the associated law that created 72(t) distributions did not define what was to be considered a reasonable interest rate. As such, the guidance from the IRS generally flows from the concept that they will not allow people to circumvent the requirement of substantially equal periodic payments (SEPP) throughout your lifetime by using an unreasonably high interest rate.
72(t) withdrawals setup prior to January, 2003, had some flexibility in the choice of the reasonable rate to use. However, in 2002, the IRS issued new rules stating that only rates less than or equal to 120% of the Federal Mid-Term rate would be considered reasonable. You are now required to use a rate that is less than or equal to 120% of the Federal Mid-Term rate for either of the two months immediately prior to the start of your distribution plan.
- Projected earnings rate
This is the interest rate you expect to receive on your retirement account.
The actual rate of return is largely dependent on the type of investments
you select. For example, from December 1999 to December 2009, the average
annual compounded rate of return for the S&P 500 was -0.6%, including
reinvestment of dividends. From January 1970 to December 2009, the average
annual compounded rate of return for the S&P 500, including reinvestment
of dividends, was approximately 10.1% (source: www.standardandpoors.com).
Since 1970, the highest 12-month return was 61% (June 1982 through June 1983).
The lowest 12-month return was -43% (March 2008 to March 2009). Savings
accounts at a bank may pay as little as 1% or less but carry significantly
lower risk of loss of principal balances.
It is important to remember that these scenarios are hypothetical and that future rates of return can't be predicted with certainty and that investments that pay higher rates of return are generally subject to higher risk and volatility. The actual rate of return on investments can vary widely over time, especially for long-term investments. This includes the potential loss of principal on your investment. It is not possible to invest directly in an index and the compounded rate of return noted above does not reflect sales charges and other fees that funds and/or investment companies may charge.
- Account balance
- This is your account balance as of the close of business on December 31st of the preceding year. The IRS has decided that the balance on this date should be used for 72(t)/(q) distributions with one important exception: this amount is increased by any contributions made for the preceding year after December 31st.
- Your age
- This is your current age. Use the age you will turn on your birthday for the year you are receiving the distribution.
- Beneficiary age
- This is your beneficiary's age. Use the age your beneficiary will turn on their birthday for the year you are receiving the distribution. This entry is ignored if you do not use your Joint Life Expectancy to calculate your SEPP.
- Choose life expectancy table
There are three different life expectancy tables that the IRS allows you to
use when calculating your SEPP with the "Fixed Amortization" or the "Required
Minimum Distribution" methods. It is important to note that once you have
chosen a distribution method and life expectancy table, you cannot change
either throughout the course of your distributions. (Except for a one-time
change from the Annuitized or Amortized methods to the Life Expectancy method,
see SEPP definition for more details). The three life expectancy options are:
Table Description Uniform Lifetime This is a non-sex based table developed by the IRS to simplify minimum distribution requirements. The uniform lifetime table estimates joint survivorship, but does not use your beneficiary's age to determine the resulting life expectancy. This table can be used by all account owners regardless of marital status or selected beneficiary. Single Life Expectancy This is a non-sex based life expectancy table. This table does not use your beneficiary's age to calculate your life expectancy. This table can be used by all account owners regardless of marital status or selected beneficiary. Choosing single life expectancy will produce the highest distribution of the three available life expectancy tables. Joint Life Expectancy This is also a non-sex based life expectancy table for determining joint survivorship. Married couples have the option of choosing this method as long as their spouse is the beneficiary on the retirement account. You are not required to choose this table if you are married, it is only an option.
- Choose distribution method
The rules for 72(t)/(q) distributions require you to receive Substantially Equal
Periodic Payments (SEPP) based on your life expectancy to avoid a 10% premature
distribution penalty on any amounts you withdraw. Payments must last for five
years (the five-year period does not end until the fifth anniversary of the first
distribution received) or until you are 59-1/2, whichever is longer. Further, the
SEPP amount must be calculated using one of the IRS approved methods which include:
- Required minimum distribution method: This is the simplest method for calculating your SEPP, but it also typically produces the lowest payment. It simply takes your current balance and divides it by your single life expectancy or joint life expectancy. Your payment is then recalculated each year with your account balance as of December 31st of the preceding year and your current life expectancy. This is the only method that allows for a payment that will change as your account value changes. Even though this may provide the lowest payment, it may be the best distribution method if you expect wide fluctuations in the value of your account.
- Fixed amortization method: With this method, the amount to be distributed annually is determined by amortizing your account balance over your single life expectancy or your joint life expectancy.
- Fixed annuitization method: This method uses an annuity factor to calculate your SEPP. This is one of the most complex methods. The IRS explains it as taking the taxpayer's account balance divided by an annuity factor equal to the present value of an annuity of $1 per month beginning at the taxpayer's age attained in the first distribution year and continuing for the life of the taxpayer. For example, if the annuity factor for a $1 per year annuity for an individual who is 50 years old is 19.087 (assuming an interest rate of 3.8% percent), an individual with a $100,000 account balance would receive an annual distribution of $5,239 ($100,000/19.087 = $5,239). This calculator uses the mortality table published in IRS Revenue Ruling 2002-62, which is a non-sex based mortality table. Please note that your annuitized SEPP is based on your life expectancy only, and is not based on the age of your beneficiary.
In addition, on July 3, 2002, the IRS ruled that you could change your distribution type one-time without penalty from the Annuitized or Amortized methods to the Required Minimum Distribution method. This would allow account holders the option to move from a fixed payment type to a payment that fluctuates annually with the value of their account. The primary reason for this exception is to allow individuals who have suffered large losses the option to reduce their distribution to prevent their retirement account from being prematurely depleted. For more information on this important exception please see Revenue Ruling 2002-62 on www.treasury.gov.
If payments are changed for any reason other than death or disability before the required distribution period ends, the distributions may be subject to a retroactive application of the Premature Distribution penalty. It is 10% (plus interest) for all years beginning the year such payments commenced and ending the year of the modification. It is important to remember that while 72(t) distributions are not subject to the 10% penalty for early withdrawal, all applicable taxes on the distributions must still be paid. Further, taking any early distributions from a retirement account reduces the amount of money available later during your retirement. Please contact a qualified professional for more information.
- Post 72(t) distribution
- This is the percentage of your account you wish to receive in annual distributions after the required 72(t)/(q) distributions have been made. This percentage will be used to calculate the annual distribution after five years have passed or your have reached age 59-1/2, whichever comes later.
Information and interactive calculators are made available to you as self-help tools for your personal independent use and are not intended to provide investment advice. We can not and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.