72(t) Gets a make over for the better for Target Employees

What is 72(t)?

72(t) payments, also known as “substantially equal periodic 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 Target.

Lets start with the 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. Therefore, 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.

IRC Section 72(t)(4)(A) provides that once an individual begins to take 72(t) distributions from a Target-sponsored retirement account, they must continue doing so over the longer of 5 years or until they reach age 59 ½ (exception death or disability).

For example, while an individual beginning to take 72(t) distributions at age 57 will ‘only’ have to maintain their distribution schedule for 5 years (because even though they would turn 59 ½ after 2 ½ years, the payment schedule must be kept for a minimum of 5 years), a taxpayer who begins such distributions at age 40 would have to maintain the schedule for nearly two decades (since they would not turn 59 ½ for another 19 ½ years)

After starting a series of 72(t) payments, the penalties for changing or canceling the payment schedule can be steep. IRC Section 72(t)(4)(A) provides that in the event a taxpayer modifies their 72(t)-payment schedule before either the end of the 5-year period or reaching age 59 ½ (whichever comes later), the 10% early distribution penalty will be retroactively applied to all pre-tax distributions taken prior to age 59 ½.

Furthermore, in these cases, the IRS will also retroactively apply interest to those amounts – that is, treating the penalty as if it had been applied at the time of distribution but had not yet been paid.

 

Penalties Are Steep

Example 1:

In 2010, at the age of 44, Mark established a 72(t)-payment schedule to make periodic distributions from his Traditional IRA. Per the 72(t) rules, the schedule was set to conclude in 2025, when Mark turns 59 ½.

Unfortunately, after properly taking distributions for a decade, in 2021 Mark (at age 55) completely forgot to take his annual 72(t) distribution, thus ‘breaking’ the schedule.

As a result of the error, the 10% penalty will be retroactively applied to all of Marks’ prior distributions, from the first one in 2010 to the most recent in 2021.

Additionally, interest will apply to the 2010 10% penalty amount as though the amount had always been owed since 2010, but had not yet been paid, resulting in 10 years’ worth of interest applied to the 2010 payment. Similarly, interest will apply to the 2011 10% penalty amount as though the amount had always been owed since 2011, but had not yet been paid, resulting in 9 years’ worth of interest applied to the 2011 payment. And so on.

The makeover is 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%.

72(t) Changes

Clearly, getting the timing of 72(t) payments correct is critical for avoiding early distribution penalties, along with correctly calculating the payment amount(s). Interestingly, the Internal Revenue Code itself provides little guidance on how to properly calculate 72(t) distributions, other than to state that they must be “substantially equal” (in fact, the excerpt above, from IRC Section 72(t)(2)(iv), is the entirety of the Internal Revenue Code’s guidance). Thus, nearly all of the guidance that we do have, with respect to how to calculate 72(t) payments, comes from other sources such as IRS Notices.

On January 18, 2022, the IRS released Notice 2022-6, which said that 72(t) payment schedules starting 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: You can’t change interest rates for a series of 72(t) payments already in place.

Additionally, the 5% rate limit is effective for any series of payments starting in 2022 or later.

This is significant for anyone employed by Target who are thinking about beginning a 72(t) schedule, since it significantly increases the maximum interest rate that can be used (and therefore the number of penalty-free distributions that can potentially be made before age 59 ½)

Consider, for instance, the  rate for October 2022 was 3.90% . Prior to the new guidance from Notice 2022-6, taxpayers beginning 72(t) schedules in November 2022 with distributions calculated using either the amortization or annuitization methods would have been limited to using an interest rate of no more than 3.90% (the higher rate from the two months prior to the month when the schedule began).

Example 2: 

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Jennifer, age 50, has recently decided to use 72(t) payments as a way to access her IRA funds without incurring an early distribution penalty, and plans to make a series of annual distributions from her IRA starting in March 2022.Jennifer’s current IRA balance is $1 million.

Unfortunately, Jennifer is not aware of the new rules provided by Notice 2022-6 and calculates her maximum annual 72(t) payment using the 3.90% pre-Notice 2022-6 maximum rate.

After using each of the three methods and available life expectancy tables to calculate her potential maximum annual 72(t) distribution, Isabelle determines that the amortization method yields the highest possible annual 72(t) distribution of using 3.90%.

However, thanks to Notice 2022-6, retirees are now able to use an interest rate of 5% instead, producing a significantly higher 72(t) distribution from the same account balance than was possible under the previous rule.

Example 3:

Doug, Jennifer’s co-worker, has recently decided to use 72(t) payments to access his IRA funds without a penalty. And he, too, has a current IRA balance of $1 million.

Thankfully for Doug, his advisor is aware of the new 5% interest rate limit for 72(t) and uses it to calculate his maximum annual 72(t) payment, to begin in November 2022.

After using each of the three methods and available life expectancy tables to calculate her potential maximum annual 72(t) distribution, Doug determines that the amortization method yields the highest possible annual 72(t) distribution of $60,312.23, a substantial increase over the 3.90% under the old rules

Common 72(t) Questions

When can I start 72(t)?
You can decide to start taking 72(t) payments from your IRA at any age.
 

How long do I have to maintain the withdrawals?

The payments must continue for at least five years or until you are age 59 ½, whichever period is longer.
 
How often do I have to take withdrawals?

 You must take the payments at least annually.

 

Can I start 72(t) payments from my 401(k) ?

The 72(t) payment plan is only applicable to the IRA or IRAs from which you calculated your initial payment. Before setting up a 72(t) payment plan, you can split your IRA into two IRAs, if that best meets your needs. You can use one IRA to calculate and take your 72(t) payments, while the other can remain available for future non-72(t) use.

 

How do I calculate payments?
 
The IRS has approved three methods for calculating 72(t) payments. Those methods are the required minimum distribution (RMD) method, the amortization method, and the annuity factor method. The RMD method will produce smaller payments than the other two methods to start out. While other methods of calculating the payments are not prohibited, it would be extremely risky to use some other method that is not officially  approved by the IRS. You should generally consult with a tax or financial advisor to calculate your 72(t) payments.

 

Can I change my method once I start 72(t) ?

You can switch to the RMD method from either the amortization or the annuity factor method. This is a one-time irrevocable switch and you must use the RMD method for the remainder of the schedule.

 

Can I stop my 72(t) payment?
 

If you do not stick to your 72(t) payment plan, or if you modify the payments, they will no longer qualify for the exemption from the 10% penalty. Here is some even worse news; the 10% will be reinstated retroactively to all the distributions you have taken prior to age 59½.

 

Can I take an extra 72(t) withdrawal because of an emergency?
 
An extra withdrawal is considered a modification of the payment schedule. Any change in the account balance other than by regular gains and losses or 72(t) distributions, will be also considered a modification and the 10% penalty will be triggered. This means that you cannot add funds to your IRA either through rollovers or contributions.
10.  You may not roll over or convert your 72(t) payments.