Rule lends flexibility to IRA withdrawals

Your Money

April 03, 2005|By Matthew Lubanko

What is Rule 72T? How can early retirees take advantage of this rule?

-- G.M., Chicago

Rule 72T allows IRA owners to take money out of their accounts before age 59 1/2 without paying an early-withdrawal penalty of 10 percent.

This is done by taking what the IRS calls substantially equal periodic payments, or SEPPs, for at least five years. The amount to be systematically withdrawn must be calculated by using one of three IRS-approved methods of figuring your life expectancy.

Taking early withdrawals is a risky strategy at a time when many people live past age 90. Withdrawals from IRAs are often fully taxed as ordinary income, so a relatively high tax rate can quickly deplete the value of an IRA and reduce your capacity to live off your savings.

To better understand Rule 72T withdrawals, let's review the basics. Then let's review a hypothetical case.

The fundamentals of Rule 72T require you to follow one of three methods to determine your SEPP: required minimum distribution based on life expectancy, amortized over life expectancy or annuitized over life expectancy.

To ensure that you choose the method that best suits your long-term needs, you should probably work with a financial planner or an accountant. To consult a helpful and comprehensive 72T calculator, visit www.nylim.com/rcg and look for a link marked "retirement calculators."

Let's begin with the fixed amortization method, using the following case study. We will assume you're 53 with an IRA worth $600,000 at the end of 2004.

Following a single life-expectancy formula - and assuming a 3.2 percent rate of interest (based on the federal midterm rate) - this fixed amortization method would pay you $2,547 a month until you turned 84. In your 84th year, you would receive 12 monthly payments of $1,029, after which your IRA balance would be drawn down to zero. This method might be a sound choice if you do not expect to live well past age 84, financial experts said.

The required minimum distribution method, which recalculates how much you receive every month based on your IRA's value at the end of a given year, is a little more conservative. This payment method takes stock and bond price fluctuations into account. In so doing, it enables IRA owners to take reduced payments in years account balances are relatively low, and accelerated payments in years in which stock and bond market rallies drive up the value of your account.

The annuitized method - the most complicated of the three - might enable you to take large sums of money in your early years of retirement. Then, after you turned age 62 and started receiving Social Security benefits, you could begin to take reduced payments.

Whatever payment method you choose, be sure to choose carefully. Once you make this choice, you must live with it until you turn age 59 1/2 , or until five years pass, whichever comes later, said John Battaglia, national personal income tax services director for Deloitte & Touche in New York.

There is one exception to this rule of irrevocable choice. Under IRS Ruling 2002-62, IRA owners who followed one Rule 72T payout method could switch payout methods if a different method would result in a lower systematic payment, said Nicholas Kaster, senior analyst with CCH Inc., a tax information publishing service based in Riverwoods, Ill.

This rule went into effect after the stock market meltdown of 2002, during which many IRAs lost 40 percent to 70 percent of their value, Kaster said.

Even with added flexibility for payout options, most IRA owners are better off not trying to exercise Rule 72T. "It's usually a good idea to keep IRA assets sheltered from taxes for as many years as you can," Kaster said.

The law permits you to forgo IRA withdrawals until age 70 1/2 , or soon after you turn age 70 1/2 ; the precise timing of required minimum distributions depends on the month and year you were born, Kaster said.

I am 51 years old. I have a $27,000 balance remaining on my 15-year mortgage that I'd like to pay off immediately. Can I escape the 10 percent premature withdrawal penalty from my IRA (levied on those who make withdrawals before age 59 1/2 ), if I use the money to pay off my mortgage in full?

-- O.W., Bethlehem, Pa.

No. The Internal Revenue Service, in IRS Publication 590: Individual Retirement Arrangements (IRAs), lists several exceptions under which withdrawals can be made from an IRA without paying a 10 percent penalty. These include:

Permanent disability.

Death. Money taken by a beneficiary younger than age 59 1/2 is penalty-free.

Out-of-pocket (uninsured) medical expenses that exceed 7.5 percent of your adjusted gross income.

Substantially equal periodic payments following one of three IRS-approved formulas.

Payment of medical insurance premiums after 12 weeks of unemployment compensation.

First-time home purchase (subject to a lifetime limit of $10,000).

Qualified higher-education expenses incurred by the IRA owner or eligible family member.

Paying back taxes (voluntarily or via forced distribution) owed to the IRS.

Withdrawal to correct an excessive contribution.

Matthew Lubanko is a Your Money columnist. E-mail him at yourmoney@tribune.com.

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