Retiring before age 50 with nearly $10 million in an employer-sponsored retirement plan can create a major tax challenge. In a Forbes analysis, Cicely Jones explains how 72(t) distributions can help younger retirees access retirement funds while avoiding the 10% federal early withdrawal penalty.
Why Taking $10 Million at Once Can Be Costly
Jones uses the example of a 50-year-old California investor with $10 million in qualified assets. She has expenses of about $15,000 a month, wants to upsize her home and hopes to help her daughter buy a home in 10 years.
If she withdrew the entire $10 million immediately, the distribution could face federal and state income taxes as well as early withdrawal penalties.
For this example, Jones calculates a 10% federal early withdrawal penalty, a 2.5% California early withdrawal penalty, a 37% top federal income-tax bracket, a 12.3% top California income-tax rate and a 1% California mental health services tax on amounts above $1 million, as per the Forbes report.
Assuming she files single, has no other income and takes the standard deduction, Jones estimates that about 62% of the total would go toward taxes, leaving approximately $3.8 million.
How 72(t) Distributions Work
Instead of taking a large lump-sum distribution, eligible retirement assets can be used for substantially equal periodic payments, known as 72(t) distributions.
According to Jones, the strategy can apply to all or part of an investor’s retirement assets and can avoid the tax penalty when the required rules are followed. She notes that the strategy is a lifetime commitment and that failing to meet its requirements can result in back penalties and interest.
Three 72(t) Calculation Methods
Jones identifies three methods for calculating 72(t) distributions:
- Required Minimum Distribution method, which changes annually
- Fixed Amortization method, which stays stagnant for life
- Fixed Annuitization method, which stays stagnant for life
For the 50-year-old with $10 million, the Forbes example produces annual distributions of $273,243 under the RMD method, $560,798 under the Annuitization method and $568,567 under the Amortization method.
The Investor Does Not Need to Use All $10 Million
The investor’s annual expenses are about $180,000, according to Jones.
Because she does not need the entire $10 million for regular income, the example considers applying 72(t) to only a portion of the assets. Jones says she could reserve a third of the funds for regular 72(t) distributions, use some money for the home purchase while taking applicable penalties, and maintain the remaining funds for her daughter’s future home purchase after age 59½.
Why 72(t) Requires Careful Planning
Jones describes 72(t) as a long-term commitment and recommends professional help to ensure the calculations and distribution requirements are followed correctly.
For younger retirees with substantial qualified assets, her analysis presents 72(t) as a way to provide income before age 59½ while avoiding the federal early withdrawal penalty.
