By Ian Berger, JD
72(t) payments have suddenly become a better deal for IRA owners and company plan participants.
Also known as “substantially equal periodic payments,” 72(t) payments are advantageous because they are exempt from the 10% early distribution penalty that usually applies to withdrawals before age 59 ½. You can take them from an IRA at any time, but only from a workplace plan after leaving your job.
There are several downsides to 72(t) payments. First, they must remain in place for at least 5 years or until age 59 ½, whichever comes later. This means a 45-year old IRA owner must maintain her payments for almost 15 years. Second, if the payments are modified before the end of the 5-year/age 59 ½ duration, you are subject to a 10% penalty (plus interest) on all payments made before 59 ½. Modification will normally occur if you change the payment schedule (e.g., stop payments), change the balance of the account from which payments are being made (e.g., a rollover to the account), or change the method used to calculate the payment schedule (except for a one-time switch to the RMD method – see below).
There are three acceptable ways to calculate 72(t) payments:
- The required minimum distribution (RMD) method. Payments are calculated like lifetime RMDs. So, they fluctuate each year. The RMD method normally produces the smallest payout among the three methods. Once you use the RMD method, you can’t switch out of it.
- The fixed amortization method. Payments are calculated like fixed mortgage payments. After using this method for at least one year, you can switch to the RMD method without penalty.
- The fixed annuitization method. Payments are calculated by dividing the account balance by an annuity factor. Like the amortization method, they remain fixed, and you can switch to the RMD method after the first year.
So, what’s the exciting news? Well, the second and third methods require use of an interest rate to calculate the amortization or annuity factor. In the past, the IRS has said this factor can’t exceed 120% of the Federal mid-term rate in effect for either of the two months before the start of the 72(t) payments. The Federal mid-term has been historically low for a number of years. For February 2022, 120% of the Federal mid-term rate is only 1.69%.
However, on January 18, the IRS released Notice 2022-6, which said that 72(t) payment schedules started in 2022 or later can use an interest rate as high as 5%. (And, if 120% of the Federal mid-term rate rises above 5%, you can use a rate as high as the 120% rate.) This is great news because the higher the interest rate, the higher the payments will be. This change allows you to squeeze higher payments out of the same IRA balance. (Note that you can’t change interest rates for a series of 72(t) payments already in place.)
Even though the RMD method doesn’t use interest rates, all three methods do use life expectancy tables. The IRS has updated the life expectancy tables used to calculate RMDs for 2022 and later years. Notice 2022-6 says the new tables may be used for 72(t) payment schedules starting in 2022 and must be used for payment schedules starting in 2023. Finally, the Notice says you won’t have a modification if you have been using the RMD method and switch from the old tables to the new tables.