Can You Avoid Early Withdrawal Penalties on Retirement Accounts?

Use a 72(t) plan to tap your retirement funds early.

Laura Adams, MBA
4-minute read
Episode #144


In this episode I’ll discuss a legal way to make early withdrawals from your retirement account without having to pay an early withdrawal penalty.

Can You Avoid Early Withdrawal Penalties on Retirement Accounts?

When it comes to saving for retirement, you can’t beat government-sponsored retirement accounts. If you’re a regular Money Girl listener, you already know about the great tax advantages you receive for keeping your money in a retirement account until you’re 59½ years old. But what happens if you need to get your money out of a retirement account before you retire?

Early withdrawals are usually not a good idea because there’s a steep 10% penalty to pay, except in certain qualified situations such as distributions for first-time home buyers, education expenses, and medical hardships. However, there’s a little-known legal loop hole that you can use to avoid the early withdrawal penalty. Before you consider this option, realize that it comes with restrictions and risky consequences.

There’s a little-known legal loop hole that you can use to avoid the early withdrawal penalty. Before you consider this option, realize that it comes with restrictions and risky consequences.

What Are 72(t) Payments?

The loop hole for early withdrawals that I’m talking about is called a 72(t) payment plan. The name comes from its numbered section of the IRS tax code. 72(t)s are also known as substantially equal periodic payments, and they can generally be used with retirement accounts such as IRAs, 401(k)s and 403(b)s.

Here’s how 72(t) payments work: You can set up a plan to take equal monthly or annual distributions out of your retirement account. The amount of money you can take out is calculated using an accounting method that’s approved by the IRS. The payment amount depends on various factors such as your retirement account balance, age, life expectancy, as well as the age and life expectancy of your account beneficiary. I’ll put a link to a 72(t) calculator in the show notes at the bottom of the page that shows how much you could receive in distributions based on your situation.

Once you begin taking 72(t) distributions from a retirement account, you must continue taking them for a minimum of five years or until you turn 59½, whichever is longer. During that time you generally can’t modify the payment amount or suspend the payments. After you’ve completed a series of 72(t) payments, and reach the age of 59½, you can take retirement distributions out of your account as you see fit. However, for most traditional retirement plans, once you reach age 70½, you generally must take required minimum distributions annually from your retirement account, whether you used a 72(t) plan or not.

Another restriction of having a 72(t) plan is that you can’t make additional contributions to the retirement account while you’re receiving periodic payments. A violation of the rules results in a 10% penalty, plus interest, on all funds withdrawn prior to age 59½.

Why Set Up a 72(t) Plan?

In these challenging economic times, an increasing number of retirement account owners have been using 72(t) payment plans to tap their money without incurring an early withdrawal penalty. If you’re facing a devastating financial hardship or bankruptcy, draining your retirement funds prematurely may be your last resort to pay for day-to-day living expenses.

Or, if you’re fortunate enough to retire early, you can use a 72(t) plan to starting spending your retirement stash. If you’re certain that you have enough retirement money to last as long as you’ll need it, you can use 72(t) distributions to pay down or eliminate debt, pay for college tuition for family members, or to supplement your current income.

72(t) Payment Plan Examples

Here’s an example: Let’s say Alex has accumulated a large nest egg well ahead of his retirement saving schedule. He decides to retire early and sets up a 72(t) plan for his IRA when he’s 50 years old. The rule is that he must continue taking substantially equal periodic payments for five years or until he’s 59½, whichever is longer. Since he’s 50, he can’t stop taking the 72(t) distributions for 9½ years, until his 59½ birthday.

Here’s another example: Sue gets downsized from her job and is offered an early retirement settlement from her company at age 58. She rolls over her 403(b) into an IRA and sets up a 72(t) plan. Even though she only has a year and a half until she reaches the official retirement age of 59½, she has to continue taking the 72(t) payments for five years, until she’s 63. At that time she can continue taking the same distribution payment or modify it to any amount that she wants.

Important Points About 72(t) Payments

An important point to remember is that 72(t) payments are subject to regular income tax (unless they were already taxed, as would be the case for contributions made to a Roth account). When a 72(t) plan is executed properly, it can be a smart way to access your retirement funds early. But when it’s set up incorrectly--with a botched payout schedule, for instance--it could result in expensive consequences. Therefore it’s important to set up a 72(t) payment plan only if it’s absolutely necessary. Never enter into a 72(t) plan lightly or count on it to bail you out of a financial mess.

The IRS rules and payment calculations for these plans are complicated, even for professionals. So if you’re interested in setting up a 72(t), be sure to consult with a competent financial advisor or accountant who has specialized experience handling them.

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More Resources:

Retirement Plan FAQ about 72(t)s

Image courtesy of Shutterstock


About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.