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Jan19, 2023

72(t) Payments, Yes or No?

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In this Great Retirement Debate, the topic of discussion is 72(t) payments, yes or no?

Episode Transcript

[00:00:00] INTRO: Hi, I’m Ed Slott and I’m Jeff Levine. And we’re two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver so that you can make better decisions because better decisions on the whole lead to better outcomes. And here’s how we’re going to do that each week. Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard earned money. Yeah, but we won’t know which side of the debate we’re taking until we flip a. Winner of the coin flip gets to pick which side of the debate they want to argue. And both of us will have to argue in favor of our respective positions, whether we agree with them or not. At the end of each debate, there’s going to be one clear winner. You a more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation, to decide what’s best for you and your family. So here we go. Welcome to the great retirement debate.[00:01:00]

[00:01:02] Ed Slott: Welcome back everyone to the great retirement debate. I’m Ed Slott, along with Jeff Levine. How you doing today, Jeff?

[00:01:09] Jeff Levine: I’m good. Ed. I, I warmed up today. I feel like I’m in peak form. I spent the last few hours arguing with my three year old. So you’re in trouble today. There’s no, no better. No better protagonist or antagonist than a three year old.

[00:01:23] Ed Slott: Did was the problem. He said, roth IRA. And you said, absolutely not.

[00:01:28] Jeff Levine: That’s right. Well, you know, Ed, my children I’ve taught them well, they knew how to roll over before they knew how to roll over. That’s uh, that’s very, we start young in this house. And, and I’ve got one for us today. And, you know, we talk a lot about those who’ve saved and who’ve kind of reached a peak and pinnacle of retirement, and what should they do. Let’s talk about someone who maybe, uh, is, has fallen on a little bit harder times or has retired early any one of these where they may need to access money in their retirement account prior to 59 and a half. Let’s say the traditional age at which [00:02:00] distributions from retirement accounts are no longer subject to a penalty. And one of the ways in which you can do so is so-called 72 T distributions named after the tax code under which effectively they’re authorized. So 72 T sometimes you’ll hear these referred to as SEPs or so SEPs. Short for a series of substantially equal periodic payments, but at the end of the day effectively, what it is, it’s a manufactured way to access money in a retirement account via payments over time that, uh, will just allow you to avoid the penalty. No, no, you don’t get outta tax. You still have to pay the tax. Everybody has to pay tax, right. But no 10% penalty. So, and we gotta flip a coin. Uh, you could flip today. I will take, I will take heads, since you always take heads, I’m taking heads.

[00:02:48] Ed Slott: All right. Let me do an actual coin tails it is.

[00:02:55] Ed Slott: Tails,

[00:02:55] Jeff Levine: all right. So you get to pick, would you like to argue that you should use 72 T [00:03:00] or that you should avoid them like the plague.

[00:03:02] Ed Slott: Uh, I will go avoid them like the plague, although I really don’t totally believe that because there are uses for them, but that’s where you’ll come in.

[00:03:10] Jeff Levine: That’s right. That’s the, if you go, if you do start to do that, Ed, we don’t have a show. We have to debate. You have one side. I have the other, that’s the way this works.

[00:03:17] Ed Slott: I say no to 72 T and a lot of financial advisors won’t like to hear that, because we get questions on that. Both from consumers and financial advisors, who, who, as Jeff said, really need to tap in to their retirement savings and the last thing they wanna do is get hit with a 10% penalty because they’re withdrawing before age 59 and a half.

[00:03:37] Jeff Levine: Right. And the, and the, and the 72 T distributions allow them to do that. So why, why so against them Ed?

[00:03:43] Ed Slott: Because I don’t like commitments. All right. Uh, to the, let me explain,

[00:03:47] Jeff Levine: I’m sending this podcast to your wife with a little note.

[00:03:50] Ed Slott: Yeah. Right. That’s exactly where I’m going with this actually. Uh, the, the rules are so strict and unforgiving, you know, the, the [00:04:00] rules generally

[00:04:01] Jeff Levine: Are you’re talking about marriage or are we back on 72 T?

[00:04:03] Ed Slott: Oh no. We’re back on 72 T. Yeah, they’ve applied to both. It, it’s a very similar, you’re going to see you’re gonna come out on my side at the end. Uh, it’s very similar, but in general, the rules, the tax rules surrounding retirement accounts are not only among the most complex in the tax code. But often rigid and unforgiving as this one is yes. The tax code allows you to access your money. If you need it before, let’s say retirement age dictated by the tax code, age 59 and a half, without that dreaded 10% penalty for withdrawing early. To me, the 10% penalty is throwing money away. It’s a deal breaker, but if you use these so-called 72 T schedules, you can get money out, you pay the tax, as Jeff said, without the penalty. So right away you might say, well, why would you be against that? Because to do that, you have to create as the name, the official [00:05:00] name, a series of substantially equal periodic payment says you have to stay on a payment plan. And here’s where the commitment comes in. You have to commit to that payment plan without changes for the longer of age of five for the longer of five years or until you reach age 59 and a half years old. Now let’s say you’re doing this at 40 years old. You’d have to stick to that commitment for 19 and a half years. Most marriages don’t last that long. And here’s the thing let’s say you were great. You did it every, every year. You came up with the right number and you’re going to need software to do this in most cases and the help of a financial advisor, because you don’t wanna break the plan, go off the commitment. Because let’s say, in my example, you’re doing okay. You know, you started at 40 and you did it perfectly took the right amount every year. You’re 15, 16, 17 years into this. And then for some reason you [00:06:00] go off the wagon, you make a change with the tax law coils of modification. Even if you take more, that’s where I see a lot of mistakes. People figure, oh, I’ll take more. IRS will love me because I’m paying more tax. No, then you’ve broken the 72 T schedule. And here’s what happens. This is a horror show of a penalty. The 10% penalty is then triggered. Retroactively for all of those back years undoing the very thing you were trying to avoid plus interest at a time when you may need the money the most,

[00:06:35] Jeff Levine: Well, you just made a good point, Ed. You need the money the most, you, you, you need the money. So it’s going to have to come from somewhere and chances are, if you’re thinking about a 72 T schedule that you’ve already exhausted your after tax savings, right? Your regular emergency fund is gone. You probably don’t even have Roth IRA dollars because as we know the contributions, there can come out tax and penalty free at any time. So you’re [00:07:00] probably stuck between a rock and a hard place and you need money. And if you need money from an IRA, There is no hardship exception to the 10% penalty. Now, one of the most common misconceptions that we run across, and Ed, I’m sure you’ve seen it hundreds of times over the course of your career is people thinking that because they’ve fallen on tough times, they can get money into their, out of their retirement account without a, without a penalty you’ve seen that I’m sure. Right?

[00:07:25] Ed Slott: Right. Have I seen that? We teach that in all our advisor training programs, it seems like every. A couple of times a year, maybe more, we see an actual court case where somebody went to tax court and pleaded with the judges that said, but I needed the money. I lost my job. Uh, I have financial hardship. Shouldn’t I be able to access my retirement account, not tax free, tax you always pay, but shouldn’t, shouldn’t I be relieved of the 10% penalty. And in every one of those cases, not almost everyone in every one of those cases, the judge has always seemed simpathetic. You’ve seen [00:08:00] some of the, uh, the court rulings where they’ll say, no, we agree with you. It’s a tough thing, but we didn’t write the tax code, the tax code lists certain exceptions for the 10% penalty and financial hardship is just not one of them. Now, some people might be watching this or listening to it, uh, or this program and saying, wait a minute, you might even be a financial advisor. Say, Ed, I don’t know if you’re right. There is a financial hardship penalty, exception. For 401k plans! No, there isn’t. What they’re talking about there, just for your own knowledge, 401k plans have a financial hardship exception, but that only allow allows you access to those funds, where you otherwise wouldn’t be, wouldn’t have that access.

[00:08:44] Jeff Levine: That’s right. You have the privilege of paying tax and a penalty. If you’re under 59 and a half, yes. Yes of using your own money. That’s what a hardship exception is. And you said that there’s this, uh, you, you said you, you, when talking about these cases that you just mentioned, you [00:09:00] referenced the fact that the judges often say there’s an enumerated list of, of exceptions to the 10% penalty and hardship is not one of them. Well, let’s talk about some of them death. That’s not good. Right? You can’t use your own money if you’re not here.

[00:09:13] Ed Slott: The ultimate hardship, but not on you!

[00:09:16] Jeff Levine: Disability. Certainly not something that you’re going to create. If it doesn’t already exist, right? Uh, education. Well, if you’re not using it for education, It doesn’t apply. A birth of a child. If you haven’t had a child or adopted a child within the last year, it doesn’t apply. They’re very narrow exceptions, right? They’re, they’re very specific case scenarios for all of these or for almost all, except the 72 T, the 72 T exception is effectively the great equalizer to say it doesn’t matter who you are. It doesn’t matter why you need the money. You need it for diapers. Fine. You need it for, uh, you know, uh, uh, rent. Fine. Do you need it [00:10:00] because you want to go on a vacation around the world. That’s okay, too. So unlike any other exception, you are effectively able to manufacture your own excuse to tap into your retirement funds for any reason. Yes. There are other restrictions you talk about, but that restriction comes with the flexibility of being able to use these dollars for any reason, for any purpose and no other exception really offers that. Unless you find yourself in an unfortunate position, like being disabled already or being dead already, your beneficiary could use the money for any reason without a penalty. But certainly we wouldn’t create a scenario where someone dies or becomes disabled just to allow penalty free access to dollars. Outside of that, all the other exceptions effectively that would apply are, uh, expense driven exceptions.

[00:10:52] Ed Slott: They’re all targeted to certain uses and you’re right. You could use that money for anything you want. You talked about a need, you don’t even have to [00:11:00] have a need. I know some people that use it just to create a flow of income to maybe invest in other vehicles. Some people use it to pay insurance premiums. And there are reasons I I’ll take your side if somebody’s maybe closer to 59 and a half, maybe. And I have used it in this case where I had somebody who was 55 years old, they left their job. Most of their money was in their retirement account. They wanted to start enjoying it. And that would be the reason you would use it. So we created this schedule form, but you still have to monitor the schedule, you know, it’s so easy to fall off the schedule to break the commitment. That’s what worries me most about these things. They have to be monitored. You have to have the exact amount.

[00:11:44] Jeff Levine: You know, Ed, speaking of the amount, there’s, there’s actually new information just as of earlier this year.

[00:11:50] Ed Slott: That’s right.

[00:11:50] Jeff Levine: That makes me feel even better about using the 72 T schedules than ever before. At least not, maybe not ever before, but at least in recent history. [00:12:00] One of the ways in which you calculate this, or one of the inputs in the calculation, there are technically three ways that the IRS is approved to calculate this. One is using what they call the required minimum distribution method, which is a lot like regular required minimum distributions for those, once they reach 72, the problem is it produces a really small distribution amount. The other two ways of going about calculating the amounts you can take out are the annuitization and amortization methods and you don’t have to know what those are. If you’re listening, candidly, most CPAs don’t even know what they are. They just open up their calculator and plug in the interest rate. But that’s the input, right? Is there’s an in there’s an interest rate that has to be used. That’s set by the IRS. And that helps to effectively dictate the maximum amount that you can take out of your IRA without a penalty. So it’s not just, when we talk about creating a series of substantially equal periodic payments, we’re not just saying, come up with a number, whatever suits you and take the same [00:13:00] amount. The IRS has, uh, very precise procedures for this. And one of the things the IRS did earlier this year is it announced that at a minimum you can use a 5% interest rate for your calculations when you go about running these, these numbers. And at least for years, we have seen interest rates incredibly low in the one to 2% range. Yeah. Thereby reducing the amount that people could take out of their retirement accounts. Now using a 5% interest rate, all you need to know today is that there’s a lot larger distribution you could take. So you have the ability to get more penalty, free dollars out of your IRA. Again, for any reason, whatever serves your purpose, then you have at any point in recent history.

[00:13:46] Ed Slott: That’s true. You could get a larger payment and that’s the key strategy. If you are going to use the 72 T payment plan, most people want to, uh, get the largest payment, but I would add on top of that, the best [00:14:00] strategy for this is to create the largest payment using the smallest amount of your retirement savings to get the most out of the least. And maybe a better strategy if you’re going to go this way is to isolate one retirement account and just use that one. So the other funds you have in other retirement accounts are not committed and don’t get hurt if you fall off the schedule on that.

[00:14:25] Jeff Levine: Yeah. So essentially Ed, right? If you have a million dollars or so here in an account, but you find you can get the amount you need to last you through 59 and a half with only $600,000. Calculating that 72 T distribution, before you start the payments split the account, put 600,000 in one account, do the 72 T distribution there. Put 400,000 in the other account. And effectively, that means that if something goes wrong, you have an emergency, there’s a leaky roof, something like that. You can still access the $400,000 in the account. You’ve peeled away without [00:15:00] breaking the schedule and triggering all those back taxes and or oh, back penalties that Ed was talking about earlier, along with interest. Now, obviously some people will find themselves in a situation where. Where they don’t, they don’t have enough, right. They, they need $500,000 to calculate the payment they really need, but they only have 400,000. Well, you can’t get blood from a stone, so you’re not gonna be able to calculate that payment even there, Ed, uh, I often suggest that, uh, people still take a little bit aside, you know, if you needed 500, but you only have 400. A lot of times, I’ll say put 20 aside in another account. And even though that does slightly reduce your payment, uh, it, it does like you’re still not, you’re getting even less than what you needed and it’s still not enough. It does mean that if you have some sort of emergency, you still have this other account in which to access. And even if you took the whole 20,000 out, in my example, you would have a $2,000 penalty because you’d have the 10% penalty on top of the income tax, but [00:16:00] you wouldn’t have the penalty on all the back distribution.

[00:16:03] Ed Slott: Right, the retroactive. What I don’t like about it, the buildup at the worst possible time. I understand, like you said, most people need the money and that’s another reason the schedule doesn’t work, especially the younger you are, the smaller the payments are. So it may not be enough to, to fill the need it’s based on life expectancy, these payments. So the younger you are, even if you are in your fifties the payments, unless you have a very large IRA are not going to be enough. And if you have a very large IRA, you probably don’t have a problem. So you may be better off if you have a one time need. And I, I hate to even say that this, if you have a one time need, maybe it’s better to take the hit and the penalty. I hate to paying the penalty because it’s just money down the drain, but it might be a better one time fix then having to get stuck with a commitment where you may end up paying that penalty [00:17:00] anyway, if you can’t stay on the schedule for all those years.

[00:17:03] Jeff Levine: Well, I think. We’ve covered a good cross section here of some of the pros and cons, but let’s just say you let’s just take a step back Ed and think of someone in this situation who’s trying to figure out what they can do or, uh, you know, they’re in need for funds. I think we both agree that, uh, whether you set up the 72 T schedule or you pay the penalty, the first thing you most likely should do in, in, again, not all, but most situations is look for other sources of dollars.

[00:17:34] Ed Slott: Oh, absolutely. I mean, we we’re assuming, and you made that assumption up front, that everything else is gone. There are no, this is the last resort. I believe this should be the last resort.

[00:17:45] Jeff Levine: What about someone who says, I don’t want debt. I, you know, I own my home, but I, I don’t wanna take a home equity loan. Would you oftentimes look for something like that before going into a 72 T discount?

[00:17:55] Ed Slott: A reverse mortgage!

[00:17:57] Jeff Levine: Yeah. Okay. I, I, I don’t necessarily [00:18:00] disagree. I mean, there’s where if you can’t get. To, uh, you know, to a, to dollars in other accounts, cause they don’t exist in your choices, an IRA distribution and setting up a 72 T schedule or perhaps, you know, tapping other assets. I mean a home is an asset and if you have equity in that asset, uh, oftentimes that can be a, a less expensive, certainly don’t need to keep the home equity line in place until your 59 and a half or until five years. So you have some more flexibility.

[00:18:27] Ed Slott: Your age is a big factor. If you’re close to 59 and a half, it may just be a stop gap measure until you’re over the threshold where a penalty no longer applies.

[00:18:36] Jeff Levine: That’s a great point. You’re only looking there, you know, if you start a 72 T distribution of 58, you’ve gotta keep that until you’re 63. If you, uh, start just taking a distribution at 60, uh, 58, you’ve only got a year and a half to go until you’ve got the ability to take all those penalty free distributions again. So absolutely. That’s a great point. But Ed, in summing up some of our key [00:19:00] pros and cons of the day. Uh, I think some of the key cons you mentioned, and, and probably the single biggest issue with 72 T distributions is the fact that they are, uh, a long and rigid schedule at the very least we’re talking about five years, but in many cases it’s a decade plus of commitment that you have to stick to and get it right for a long time. And the other challenge with these distributions is that you don’t get to make the amounts up yourself. You have to stick to a calculation and that’s limiting the dollars that you can take out at any one time on the pros Ed, we said that, uh, one of the biggest pros relative to all the other exceptions that are available is that you can effectively manufacture this one for yourself. It doesn’t require some sort of nasty event, like a death or disability to happen first. It doesn’t require that you spend the dollars on certain things such as education or home purchase, etc., as other exceptions do. So this one is just if you want the dollars and you adhere to the schedule, you can do whatever you [00:20:00] want with those dollars. And because of a change in the way that payments are calculated with a new IRS interest rate set earlier this year, a minimum interest rate, uh, that can be used. There’s an ability to take more dollars out of retirement accounts, penalty free using this method that at any time in recent history, anything else you’d add to, to those as key takeaways for our listeners today?

[00:20:23] Ed Slott: The concept in all 72 is if you’re going to do it, get the largest payment, using the least amount of retirement accounts, if you can. But I know Jeff, when you close up this program, you are, as you always say, use a financial advisor. This is one I would not try at home alone.

[00:20:43] Jeff Levine: I don’t think I’d even try this one at home alone. I think if I ever need one of these and hopefully I don’t, I’m coming to you, Ed.

[00:20:50] Ed Slott: And I’m going to some computer program and I’m gonna print it out like I used to do for my clients and check it off each time to make sure they made the exact payment. And even then sometimes [00:21:00] they make the wrong payment.

[00:21:01] Jeff Levine: Mistakes happen and, and that’s why you need a professional. And, and that’s why, and that’s also why, while there are two sides to every coin, Ed, life and retirement decisions, when they’re this big, can’t be left up to that coin flip. So one thing you and I always agree on is when these big decisions occur. Anytime there’s, uh, a life changing decision or just a decision with significant financial consequences. It’s best to talk through the decision with a knowledgeable financial advisor or a tax professional so that you can weigh the pros and cons of those decisions against your own set of specific goals and objectives. Now, if you’d like to continue the discussion with Ed or I we’d love to hear from you, you can reach out to us on social media. You can reach Ed on Twitter @TheSlottReport. Again, that’s the @TheSlottReport and you can reach me on Twitter @CPAPlanner. Again, that’s @CPAPlanner. Let us know what you think of 72 T distributions. Do you like them. Do you not? Have you used them before, uh, any specific set of pros or cons, uh, that you thought we [00:22:00] missed or should have spent more time on, or you have a topic for a future debate for Ed and I. We’d love to hear from you until then Ed, as always. It’s been fun.

[00:22:09] Ed Slott: All right, sounds good. Jeff, we’ll see you on the next episode of the great retirement debate.

[00:22:16] OUTRO: Jeffrey Levine is Chief Planning Officer for Buckingham Wealth Partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice. Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but it’s accuracy and completeness cannot be guaranteed. The topic discussed in corresponding arguments are those of the speakers and may not accurately reflect those of Buckingham Wealth Partners.