Early Retirement Made Easier: Creating a Sustainable Income with 72(t) SEPP Distributions
We’re early retirees sharing why we are doing 72(t) SEPPs, what we considered in setting up 72(t) SEPPs, and how we implemented them as part of our early retirement income stream. In this blog, we’ll also highlight why we think early retirees underutilize the 72(t) SEPP as an income source.
While there’s a lot of content on accumulating wealth and getting to financial independence, what we haven’t seen in the financial independence community are actual examples of people drawing down their assets in early retirement. Importantly, we see very few financial independence bloggers, vloggers, or podcasters sharing information on their retirement income streams, including 72(t) strategies.
About Us
Darren and I are early retirees who left corporate careers in our late 40s. We are nomadic except for three months a year when we spend time in our tiny home in the Great Plains of the United States.
We spend 40 - 120 days per year thru-hiking in the EU and about 90 days yearly in the Caribbean and Central America. This blog documents our journey to nomadic living and financial independence and the adjustments we’ve made to make the lifestyle work.
We’re not financial advisors, lawyers, accountants, or tax experts. This content is for information, entertainment, and educational purposes only. We’re simply telling you why we are choosing to do 72(t) SEPPs and how we got the first one set up.
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What is Retirement Income?
Perhaps you are early retired, vocationally independent, working part-time in fun-employment, volunteering, or working on a passion project. You might wonder how others (and you) might build an income stream to cover expenses in retirement.
Income may come from any number of sources. Typically, for early retirees, income is from rental properties, a defined pension plan, a small business, patents, consulting, and/or a defined contribution plan such as a 401(k), 403(b), and 457. Other sources of income may include inheritance, disability benefits, a severance package, and the sale of real estate or a business.
Later in traditional retirement, more income sources may be realized, such as Social Security and reverse mortgages.
Retirees often have multiple sources of income that include a combination of the items listed above.
Whew, that’s a lot of potential income sources, large and small. Yes, it can get complicated. We rarely see sample early retiree income streams visualized, showing how others fund their retirement.
What is Rule 72(t)?
With few exceptions, withdrawals from an IRA before age 59 ½ incur a penalty of 10% in addition to income taxes that are owed. There are, however, some mechanisms to access defined contribution funds in early retirement, typically before age 59 ½.
The IRS tax code has a section called Rule 72(t), hence the name. The rule allows you to set up substantially equal periodic payments (SEPP) to withdraw funds from an IRA prior to reaching age 59 ½ and avoiding a 10% penalty. By setting up a 72(t) distribution schedule, you avoid the 10% tax penalty on early withdrawals if you follow all the rules. You will still, however, need to pay income tax on your distribution each year.
What is a SEPP?
The IRS Rule 72(t) allows investors with Substantially Equal Periodic Payments to receive substantial and equal periodic payments to themselves from an existing 401(k), IRAs, 403(b), 457(b), and/or Thrift Savings Plan (TSP)
When setting up a SEPP before age 59 1/2, there are a few things to keep in mind:
You must receive payments minimally once per year, for five years or until age 59 ½, whichever is the longest. For example, if you set up a SEPP at age 50 ½, you’ll need to take annual distributions every year until you reach 59 ½. On the other hand, if you set up a SEPP at age 57, you would need to continue the distributions until you reach age 62.
If the money has not been taxed (like in a Rollover IRA), you must pay federal and state income taxes on distributions. If you domicile in a state like South Dakota or Tennessee that does not have state income taxes, then state income taxes do not apply.
You can’t set up a SEPP for a 401(k) associated with a job you are still working in. You’ll need to quit that job and roll your 401(k) money into a Rollover IRA. Be sure to consult your accountant and brokerage firm (e.g., Charles Schwab, Vanguard, Fidelity) to walk you through rolling over an IRA.
Why Do a 72(t) SEPP?
First, let's look at reasons why any early retiree looking for retirement income may want to access IRA funds in early retirement by utilizing 72(t) distributions. Later we will discuss why we decided to proceed with a 72(t) SEPP.
You plan to or have already retired early (before 59 ½) and want to access IRA money and avoid the 10% early withdrawal penalty.
You want to reduce the amount of money in your retirement account(s) as part of a larger lifetime tax management strategy. As an early retiree, you will likely find yourself in a lower tax bracket than you were in your working or accumulation years.
You need some income from retirement accounts. Maybe you’re an early retiree who has sufficient retirement savings or who is overfunded in your tax-advantaged retirement accounts and underfunded in other income sources and brokerage investments.
You are an early retiree who can commit to periodic distributions for five years or until you reach 59 ½, whichever is longer.
You’re an early retiree who understands the IRS rules and limitations on the 72(t) distribution.
You’re an early retiree who has a sound investment strategy, meaning that you know that the IRA funds dedicated to the 72(t) should be invested and grow to support the withdrawal strategy.
You are an early retiree and are aware that the 72(t) limits flexibility on the funds assigned to the 72(t) account; that you can’t concurrently do Roth conversions on funds in that account. You know you can’t add or subtract from this account until you have completed all your SEPPs.
What to do Before Setting up a 72(t) SEPP
If you think a 72(t) SEPP plan might fit a portion of your retirement income, there are a few things you’ll need to do before setting up the 72(t) SEPP. There are several retirement planning tools like NewRetirement available for a low cost (under $300 per year) that will enable you to test several retirement income scenarios, including 72(t) SEPP and Roth conversions.
Review your Retirement Budget and Income Streams
For example, if a pension will generate enough money to cover 50% of your living expenses, you may only want to set up a SEPP equal to 50% of your anticipated budget to cover the rest.
Be sure to consider the potential tax impact from the 72(t) distributions, particularly if you have other sources of income and/or will inherit an IRA during the SEPP distributions.
We waited until we were three years into early retirement to set up our first 72(t) so that we would have a better handle on what our semi-nomadic lifestyle would cost and have a better idea about our other sources of income.
Know the Tax Implications
There are a couple of points relative to taxes to carefully consider before beginning a SEPP.
First is to recognize that the SEPP distributions are taxed as ordinary income at the Federal and State (if applicable) levels. So, your tax rate will depend on your overall income, filing status, and applicable tax rates.
Second, you’ll need to determine how you will pay the taxes. Either have sufficient funds from another source (e.g., a brokerage account) to pay the taxes, or plan to do so with some of your distributions.
Decide the Accounting Methodology for Distribution
There are three methods for determining the distribution of funds for Rule 72(t):
The required minimum distribution method
The fixed amortization method
The fixed annuitization method
For more information on how these calculations are done, check out this informative blog post by CPA Ed Zollars.
You’ll choose one of these methods when initiating your 72(t) and are allowed to change the calculation method one time during the SEPP distribution period. Know the Inflexibility
Know the Inflexibility
Consider the inflexibility of the 72(t) distribution plan once it starts; you cannot modify the distribution amount or frequency during the chosen period, except the ability to change the calculation methodology one time during the distribution period.
Select the Retirement Account You Will Begin Distributions From
Determine which retirement account(s) you'll use for the 72(t) distribution, such as a traditional IRA or 401(k).
Know the Investment Strategy for the Money Inside the 72(t)
Plan an investment approach that aligns with your income needs and risk tolerance during the distribution period. Assess your asset allocation and how it may need to be adjusted to support the 72(t) distribution. You can manage investments within this account, including rebalancing as needed and selling funds inside the account.
When setting up our 72(t) automatic annual distribution with our brokerage house, we elected to have money market funds distributed, rather than having investments traded at the date of distribution. This way we can preemptively trade what and when we choose prior to the distribution date.
Be aware of the sequence of returns risks. Be aware of the impact of market fluctuations on your 72(t) distribution plan, especially during downturns. You can’t turn off the distributions.
You may wish to consult with a retirement income and expense software like NewRetirement if you are having difficulty penciling all the scenarios out. You may want to consult with a Fee-only Financial Advisor who specializes in retirement income planning. Also, you may want to consult with your accountant or other tax professional if you have tax questions.
Understand the Impact of a 72(t) on Your Nest Egg
By taking distributions on your IRA, whether through a 72(t) or from any other distribution, you are reducing the amount of money that will be there later in retirement. How much depends on the investment returns during the period and the time you take the money out of the market, which is unpredictable when you are setting up this process.
We do know that there is an opportunity cost by taking funds out and spending them.
In this random example below, a 50-year-old investor takes a $750,000 IRA and partitions off $500,000 to a separate IRA account they will then initiate a 72(t) distribution from. While taking SEPP of $30,000 per year (using the amortization methodology) and keeping the balance invested in low-cost index funds, assuming 7% growth, the investor harvested $300,000 from the IRA over ten years and still has over $500,000 left in the IRA.
What were the opportunity costs? The opportunity cost this investor could have missed out on was the growth and dividends associated with the $300,000. Again, without knowing what the returns would be over those 10 years and the timing, it is impossible to truly know the amount of money they gave up.
What we do know is that we are not getting younger. Our 50s will be the most active period of our early retirement. For us, we’re happy to miss out on the loss of these potential yields and not miss out on the healthiest and most active years of our retirement.
How We Started Our 72(t) SEPP
Once we understood all the benefits and risks of the 72(t), we proceeded with setting up one 72(t) with one of our Rollover IRAs.
We first contacted the brokerage house where our Rollover IRA is serviced. We did this by calling their 1-800 number and finding the department that supports retirees interested in 72(t). We informed them we wanted to start a 72(t) on one of our accounts. They informed us of the risks (the same ones we mentioned above) and confirmed with us that we understood them. Once we confirmed that we understood the risks (and rewards), they helped us with the next step, which was to create a second IRA account, since we only wanted to start distributions on a partial amount of the initial IRA. Within an hour or so, we could see two Rollover IRA accounts showing up on our online dashboard—the original IRA and a new IRA account number with a Zero balance. This portion of the process took 30 minutes.
With the second IRA account visible, we made the amortization calculation. Based on our numbers, we left ⅓ of the original IRA funds in the original Rollover IRA account (and labeled it original IRA). We called the brokerage house to move ⅔ of the money into a new IRA account (72t). We called the brokerage house since they can move funds directly from one IRA to another as an in-kind transfer, without having to sell and then rebuy the investments. This whole process took less than 20 minutes.
Once the funds have moved into the new account, then we went to the brokerage house forms page as directed and download the documentation for setting up a distribution. Fill out all the boxes and call them with any questions.
Once the documents were filled out, we saw on the last page that we needed a Medallion Signature Certificate, or signing the form at one of the brokerage firms' offices was required to execute the 72(t) SEPP.
As we were at our temporary home base in the Great Plains, we found no Medallion Signature Certificate officials in the area. We did find that the brokerage house had some locations in the Midwest that could complete the forms for us. The closest one was three hours away, but we also found one in another city that we were traveling to later that month.
We called that office, and they confirmed that we could just walk in, have the IRA owner sign the document, and they would affix their certification and submit the documents for us. When we arrived at the branch, they asked for ID (e.g., driver's license). The documents were then signed and submitted. That process took about 15 minutes.
Once we returned from our short trip, the IRA account owner logged in and could see that an annual distribution was planned for the next month and that the end date of the distribution was when that person turns age 59 and 184 days, just as we had requested.
What We Did After Our First 72(t) SEPP Was Set Up
First, we celebrated! A portion of our retirement income is secured for the distribution period, which in the case of this 72(t) is another ten years.
Second, we confirmed through the brokerage house portal that our distributions are set up as intended—annually. In August of each year, we will ensure that the annual periodic payment happens as scheduled. Otherwise, we will incur a significant penalty!
At age 59 ½, we can make further distributions from our qualified accounts, or change or continue the distributions, whatever we desire at that time.
Make sure that you have a beneficiary assigned to the account. In this case, the account owner assigned the spouse as a beneficiary on the 72(t) account.
We informed our accountant that we have finished setting up the 72(t) and when the first periodic payment will occur so that we make sure we pay our quarterly taxes correctly with this new information.
With the funds remaining in the Original Rollover IRA, we plan to do a small Roth conversion before year-end to fully take advantage of our 12% tax bracket for 2023, as we’ll have an excellent idea of what our income will be for 2023 at that time.
Can I (or the Household) Do More than One 72(t) SEPP?
Yes, you can do more than one 72(t) SEPP. You can do multiple 72(t) distributions on multiple qualifying IRA accounts. In a nutshell, you can build a ladder of SEPPs if you like. For more on 72(t) laddering, check out this podcast where The Millionaire Educator uses 72(t) laddering as a portion of his income stream in early retirement
If you are part of a former dual-income household, your spouse can do one (or a ladder of distributions) as well. The younger of us will start up their own 72(t) SEPP in a few years once we’ve had a couple more years of early retirement under our belts.
Suppose one of us does decide to go back to work before we die. In that case, we’ll make sure that new money into an IRA goes into a new qualified retirement account so that those new monies don’t interfere with the 72(t) account or any accounts upon which we are doing Roth conversions.
Why More Early Retirees Aren’t Using the 72(t) SEPP
There are several reasons why more people may not opt for 72(t) distributions as a retirement income strategy:
Many early retirees are simply not aware of the 72(t) and its potential benefits as a retirement income option.
Some early retirees may think that setting up one is complex. Spoiler alert, if you’ve figured out how to save and invest and retire early, you’ve got what it takes to set up a 72(t). The project will take about 40 hours to learn and read up on and less than 8 hours to execute.
The Rule of 72(t) is not flexible. It’s not supposed to be. Uncle Sam wants you to keep that money in your account and have it compound until age 70-something when you’ll need to take RMDs at (likely) a higher tax bracket. Know the inflexibility and work with it.
Perhaps the early retiree does not have enough cash in a liquid account to pay the annual taxes. It is, however, possible to pay the taxes with the money distributed.
Some early retirees might not need the income. You likely have other sources of income, such as pensions, rental properties, or side businesses, making 72(t) distributions unnecessary.
Some early retirees may be afraid to take action because they fear making mistakes or doing something different than what others are doing or are afraid of making a mistake that has significant tax consequences.
One concern that may stop some from setting up a 72(t) is market performance and sequence of return risk. Retirees relying on a 72(t) distribution plan face sequence of returns risk on the portion of money assigned to the 72(t). Market downturns early in the distribution period can significantly impact income sustainability throughout retirement. We agree with this concern. However, it is a risk we are willing to take.
What are some other reasons more early retirees are not using a 72(t)? Let us know in the comments section below.
In Conclusion
We are a dual-income, childfree couple who utilized our employer 401(k) and Roth accounts to save and invest while we were working. By aggressively saving and spending less than we earned over 20+ years, we achieved financial independence in our late 40s.
All this saving and investing did cause a problem. It meant a significant portion of our wealth was “locked up” in tax-advantaged accounts. We started researching approaches to taking out this money that would not have a 10% early withdrawal penalty associated with it. We liked that the 72(t) SEPP would provide annual income and likely leave the principle intact over ten years.
Understanding all your income streams through your 50s, 60s, and beyond will help you decide if a 72(t) SEPP in your 50s is a good plan, not only for income in early retirement but as a savvy way to reduce taxes. We had modeled tax scenarios in the NewRetirement planner. Taking substantial periodic distributions and doing Roth conversions in our 50s was a good way to reduce our taxes in later years. We’re withdrawing a small portion year after year, reducing the compounding inside the tax-deferred account.
Remember that the decision to set up a 72(t) distribution is significant and can have long-term consequences. Thoroughly understand the rules and carefully consider your household's financial situation before proceeding.
