72(t) Fixed Annuitization Rules

by Leslie McClintock, studioD

In most circumstances, those who are under age 59 1/2 who want to take money out of their retirement accounts or annuities must pay a 10 percent penalty to the Internal Revenue Service. This is in addition to any federal and state income taxes that may be due. This is normally a disincentive to those who want to retire early. Congress makes an exception to the rule, however, under Section 72(t) of the Internal Revenue Code.

Rule 72(t)

Section 72(t) allows retirement-plan owners and annuitants - that is, beneficiaries of annuity income streams - to avoid the 10 percent penalty on distributions from retirement accounts and annuities, provided the investor commits to spreading the income evenly across the number of years in his or her remaining life expectancy.

Joint and Survivor Payouts

The account owner or annuitant also has the option of selecting a "joint and survivor," or "second to die" option on the payout. When this occurs, the investment company or insurance company acting as the account custodian calculates the life expectancy of the account owner and his or her spouse, or such other individual as the account owner designates. The company uses actuarial tables to calculate how much it can pay each month, or each year, assuming it will pay benefits as long as the second person to die continues to live. In this way, an annuitant can guarantee that his widow will have an income as long as she lives and will never outlive her income. Payouts are lower with joint-and-survivor payouts than they are on payouts made over a single life expectancy.

Qualified Plans

If you want to make distributions from a qualified employer-sponsored plan, such as a 401(k) plan, you must leave the company prior to beginning the payments. You cannot continue to work at a company while taking 72(t) distributions from the company plan.

Substantially Equal Periodic Payments

In order to qualify for the 72(t) exception to the 10 percent penalty, you must take the payout in "substantially equal periodic payments" over the course of your life expectancy as defined by the IRS's own mortality tables. You must also not substantially modify these payments for at least five years after commencing the payments, or the IRS will charge you the penalty on withdrawals.

The Fixed-Annuitization Method

The Fixed-Annuitization method is one of three authorized methods for calculating the substantially equal periodic payment amount. Under this method, the investment company elects a specific interest rate, approximating the market rate on money at the time the stream of income commences. They then use that interest rate to discount the net present value of an income of $1 per year, according to an approved IRS actuarial table. Then they divide the total account balance by this figure. This is the annual income the annuitant or annuitants will receive during the year. Under this method, the annual payout does not change once the income stream commences.

About the Author

Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.

Photo Credits

  • Gold Nest Egg Open With Dollar Inside image by Scott Maxwell from Fotolia.com