Divorce the IRS

The 72(t) Rule Could Change Your Retirement Tax Strategy

• James Miller

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Most people assume that if they access retirement accounts before age 59½, they’ll automatically face a 10% early withdrawal penalty.

That’s not always true.

In this episode of The Divorce the IRS Podcast, we break down one of the most overlooked retirement tax strategies available today: the 72(t) strategy, also known as SEPP (Substantially Equal Periodic Payments).

This IRS-approved strategy allows certain investors to access money from traditional IRAs and other qualified retirement accounts before age 59½ without triggering the typical 10% early withdrawal penalty.

We explain how the 72(t) rule works, who typically uses it, and why it can become an important planning tool for people pursuing early retirement or trying to create tax-efficient Roth conversion strategies.

You’ll learn how some investors use 72(t) distributions to create an income stream that can help pay taxes generated by Roth conversions, potentially allowing them to move larger amounts of money into tax-free Roth accounts over time.

We also discuss the important rules and risks surrounding the strategy, including required withdrawal schedules, IRS-approved calculation methods, the five-year commitment requirement, and why proper planning is critical before implementing this type of strategy.

If your goal is to create more tax-free retirement income, reduce future tax exposure, and understand advanced retirement planning concepts, this is an episode you won’t want to miss.

In This Episode

• What the 72(t) / SEPP strategy is
• How to access retirement accounts before age 59½ without penalties
• The difference between 72(t) and 72(q) strategies
• How 72(t) distributions may support Roth conversion planning
• Why Roth conversion taxes stop many investors from converting
• Why using retirement money to pay Roth conversion taxes can create penalties
• How the 72(t) strategy may help avoid the 10% early withdrawal penalty
• The three IRS-approved withdrawal calculation methods
• Differences between the RMD, annuitization, and amortization methods
• Why the RMD method is generally more conservative
• The five-year rule for 72(t) distributions
• Why you can only make certain calculation changes once
• How investors can isolate only a portion of their IRA for a 72(t) strategy
• Why proper financial planning is critical before implementing advanced tax strategies

What’s Coming Next

• The Rule of 55 and how it works
• Advanced Roth conversion planning strategies
• Tax-free retirement income concepts
• Backdoor and Mega Backdoor Roth strategies
• Retirement tax planning mistakes to avoid


SPEAKER_00

Welcome to the Divorce the IRS Podcast, the retirement income planning podcast designed specifically for those who want to pay the least amount of taxes possible and build a retirement income that lasts. Inspired by the best-selling book, Divorce the IRS, you get to go behind the scenes with financial planner, author, and speaker Jimmy Miller. Learn how to set yourself up to pay the least amount of taxes in retirement when you'll need your money the most. And now, here's your host, Jimmy Miller.

SPEAKER_01

Welcome. Welcome to episode 23 of the Divorce IRS Podcast. Today we're going to discuss a strategy that most people don't know about. This little known strategy called 72T or SAP strategy, which stands for substantially equal periodic payments, SEPP, allows someone to access their pre-tax accounts, like their traditional IRAs, before the age of 59 and a half and without any early withdrawal penalties. Let's dive right in. Now the 72T strategy is known mainly by those who are seriously investigating the idea of retiring before they're 59 and a half years old. 72T refers to the portion of the IRS code that allows a person to access the money in their tax me later bucket, like from their traditional IRA, before they are 59 and a half years old without incurring the 10% early withdrawal penalty. The 72T applies to IRAs and other qualified monies. And its close counterpart, the 72Q, is for access to non-qualified money, like non-qualified annuities, which are tax-deferred investments like a traditional IRA. But 72T and 72Q don't have to be just for those who want to retire early and access their qualified retirement accounts before 59 and a half years old without penalties. There can be another use for this strategy as well. Now, depending on your personal situation and where you are in life, if you're really serious about divorcing the IRS and living a tax-free retirement, it is vitally important to understand these legal strategies because the biggest impediment to Roth conversions is that whopping tax bill that can come with the Roth conversion. Paying tax on all that tax-deferred money is a hard pill to swallow, even if you know you will owe all that tax and likely more down the road anyway. This big tax bill stops most people from converting their money, coupled with the fact that if you're under 59 and a half years old, you shouldn't use any of the money from the conversion account to pay the tax, as this will trigger the 10% early withdrawal penalty. Roth conversions feel out of reach for many people, but they don't have to be though, with proper planning. The 72T and 72Q allow you to carve off a portion of your tax-deferred money and start withdrawing it at any age without any 10% early withdrawal penalty. Now you'll still owe the tax on the money taken out, but you were going to owe those taxes anyway, whether you took the money out now or later. So this creates a stream of income each year, and you can use this money to pay for the taxes caused by enacting Roth conversions on another portion of your tax-deferred money. This basically allows you to use the money in your tax-deferred bucket to pay the taxes due on the conversions without subjecting yourself to the 10% early withdrawal penalty. Now it's always better, if you're able, to find another source of money to pay Roth conversion taxes from. But for those who find themselves mid or late career with most of their wealth tied up in home equity along with their IRAs and pre-tax 401ks, and no significant liquid savings, using a 72T strategy can often make sense, if done correctly. Of course, there are several rules surrounding 72T and 72Q that you should know about. It's best for most people interested in the strategy to work with a qualified financial advisor to make sure they're following all the rules and that it makes good sense within the context of their overall financial plan. Here are the most important rules you need to know about the strategy. If you start this strategy, you must keep it going for five years or until you're 59 and a half years old, whichever period is longer. You can stop the program once this requirement is met if you'd like. And unlike the rule of 55, which we'll talk about in the next episode, you cannot take out any amount of money you choose from your IRA. There are three approved IRS methods for calculating how much money you can withdraw each year, all resulting in different amounts of money. They are the required minimum distribution method, the annuitization method, and the amortization method. Now the annuitization and amortization methods allow you to withdraw the greatest amounts of money, but require you to withdraw the same amount each year until you finish the program. The RMD method allows you smaller withdrawals, but lets you calculate the amount each year based on a life expectancy table and the previous year end balance of your IRA. Now this will result in a different amount you can withdraw each year, and it usually rises over time with the value of your account. The RMD method is the more conservative of the three calculation methods. Now, if you choose the higher annuitization or amortization method for your calculation, you can switch, but one time only, to the RMD method. However, you cannot switch the other way from the RMD method to either of the other two methods. Another very beneficial provision is that you can apply this strategy to just a portion of your tax-deferred money. This is usually accomplished by moving only what you'd like to run your 72T and 72Q calculations on into a separate IRA or non-qualified annuity. Then you have control over the strategy and can be very precise in how you withdraw the money for the tax bills created by your Roth conversions. If you're a little closer to the retirement finish line than the starting line, and you want a more in-depth look at using 72T and 72Q, read the second case study in the divorce the IRS book. We'll also have an episode covering that case study here in the podcast as well in the future. In the case study, I outline exactly how an example couple utilizes this strategy to get large amounts of money converted to tax-free accounts and how it all works out for them. Measure twice and cut once. That's a great saying. Make sure to employ this wisdom when executing Roth conversion or 72T strategies. It never feels good to make a mistake and pay the IRS more than you need to. With careful planning, though, you don't need to make a mistake in executing Roth strategies. Whatever your current situation, there are many options, from regular funding of a Roth IRA to the backdoor strategy, to the mega backdoor Roth strategy, to conversions, and now the 72T and 72Q strategies. They're all worth considering before you look at life insurance, which we'll discuss after we break down the rule of 55 for you. So stay tuned.

SPEAKER_00

Want even more ideas, tools, and resources on how to navigate through financial life? Check out all the resources on the Divorce the IRS website at divorce-the-IRS.com or the Bayob Wealth website at Bayobubwealth.com and subscribe to the blog to stay up to date on issues affecting retirement income planning. Don't forget to subscribe to the podcast so you never miss an episode. Bayobub Wealth and Bayabub Wealth Abroad are DBAs of Bayob Wealth LLC, a Florida registered investment advisor. This podcast is designed for general education purposes only and shouldn't be taken as legal investment or tax advice. You should seek out a qualified tax professional or licensed financial advisor to determine what is best for your personal situation.