Using 72(t) rules for penalty-free income

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Dear Liz,
If you are retiring early (around age 50) and quitting your job, can you use the 72(t) rules to draw money from a 401(k), a 403(b) and a Roth IRA to get penalty-free income? Do you need to figure the amount separately, or can you make withdrawals based on all the accounts combined? Finally, can you work a part-time job or earn some income and still take advantage of this rule?
— Austin

Dear Austin,
Retirement account withdrawals before age 59 1/2 typically incur penalties, but there are a few exceptions. One of those exceptions, outlined in Section 72(t) of the IRS code, allows penalty-free withdrawals for a “series of substantially equal periodic payments.” These payments are based on your account balance and your age. You won’t be able to take big lump-sum withdrawals, since the amounts are based on life expectancy — in other words, they’re designed to stretch out the payments over your remaining lifetime. The payments must continue for at least five years or until you turn 59 1/2, whichever takes longer.

You don’t have to quit your job or avoid earning income to use this exception. You also have some flexibility in how you figure the withdrawals, since the IRS allows three different methods. You can read about the details in IRS Revenue Ruling 2002-62.

You should know that 401(k)s and 403(b)s typically have distribution rules that don’t allow 72(t) withdrawals, says Mark Luscombe, principal analyst for CCH Tax & Accounting North America. You could roll the balances into IRAs and then take 72(t) distributions, however.

Also, your Roth IRA allows you to take out all the money you’ve contributed without paying taxes or penalties, so setting up a 72(t) might be unnecessary.

A few things to keep in mind: Withdrawals under this method may avoid penalties, but they don’t avoid income taxes (except when taken from the Roth). Also, early withdrawals from retirement funds increase the odds you’ll run out of money, particularly if your investments do poorly.

This is a complicated area and it’s easy to make a mistake, so get the advice of a retirement adviser familiar with the 72(t) rules — and the potential effect on your finances — before you continue.

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