With a struggling economy and unemployment at over 9%, more families may need to rely on their IRA to meet current income needs prior to reaching age 59½. While clients may not be able to avoid paying taxes when tapping into their IRA, they can avoid the 10% early withdrawal penalty with a properly structured 72(t) distribution arrangement. The payment schedule must be established for five years or until the client has reached age 59½, whichever is longer, in order to avoid the 10% premature distribution penalty on withdrawals. Although drawing down IRA assets prematurely is not ideal, there is some flexibility in structuring a 72(t) distribution schedule to meet the client’s current income needs.

The method makes the difference
Rule 72(t) provides individuals with the flexibility to choose one of three “approved” calculation methods to determine withdrawals – the life expectancy method, the annuity method, and the amortization method.

Life expectancy method. The life expectancy method divides the IRA account balance by a divisor from an IRS single or joint life expectancy table. This method results in payment amounts that fluctuate each year, allowing the IRA owner to withdraw the least amount of income.

Annuity method. The annuity method uses an annuity factor, provided by the IRS, to calculate substantially equal periodic payments. This method provides individuals with steady fixed annual payments.

Amortization method. The amortization method calculates the annual distribution amount by amortizing the account balance over single or joint life expectancy. This method, which provides fixed annual payments, may be appropriate for individuals who would like to withdraw as much as possible from their IRA.

Comparison of distribution methods*

Distribution Life expectancy Annuity Amortization
Year 1 $2,924 $5,337 $5,416
Year 2   3,148   5,337   5,416
Year 3   3,400   5,337   5,416
Year 4   3,661   5,337   5,416
Year 5   3,940   5,337   5,416
Total $17,073 $26,885 $27,080

*Hypothetical example assumes a 50-year-old traditional IRA owner, an account balance of $100,000 with an 8% annualized rate of return, and an interest rate of 4% in conjunction with the IRS mortality table. Performance is not indicative of any Putnam fund and will fluctuate.

Additionally, since 2002 (IRS Revenue Ruling 2002-62), individuals are allowed to change their distribution type one time from either of the fixed-dollar (“amortization” or “annuitization”) methods to the variable (“life expectancy”) method without a penalty. It’s important to note that once the account is changed to the life expectancy method, that method must be used in all subsequent years.

Customizing an income stream
In many cases, the client is looking for a specific amount of income from his or her IRA to supplement other sources. It’s possible to structure a precise 72(t) payment schedule by choosing a method and determining how much IRA assets are needed to create that preferred income stream. For example, let’s assume a 50-year-old client’s IRA is valued at $500,000 and he or she is are seeking roughly $10,000 in income from the IRA each year. At current interest rates, the life expectancy method would yield approximately $15,000 in annual income or $5,000 more than desired. To attain the income goal of $10,000 annually, the IRA could be split into two separate accounts – one with a 72(t) distribution and one without. For this example, an IRA of $350,000 will generate approximately $10,000 in annual income. The client would separate the $500,000 IRA into two parts – $350,000 with a 72(t) distribution and $150,000 of IRA assets without a distribution.

Lastly, taking premature distributions from an IRA requires careful consideration. Early withdrawals result in higher current taxes and reduce the amount of money ultimately available during retirement, and should be pursued only after other options have been explored.

For more information, download our investor education piece, 72(t): Looking for a way to supplement your income?