If you’re like most Americans in the workplace, you probably at one point got suckered into opening up some sort of retirement account such as a 401(k) or an IRA. There are a multitude of reasons (mostly political) as to why these plans have become so mainstream, despite not being the best place to store your hard earned cash. In fact, the traditional retirement accounts are actually a pretty terrible place to invest your savings given the amount of restrictions they come with. One of these restrictions, is the penalty you will pay to the IRS for taking a withdrawal from your retirement account before you reach the designated age of retirement.
For example, if you were to take a distribution from your 401(k) early in life, prior to being “retired,” in addition to the regular income tax you will pay, you will also get hit with a 10% penalty from the IRS when you go and file your taxes. This makes it generally undesirable to withdraw your cash early.
The reality is that the best time to invest your money is when you’re young and if most of your savings is tied up in a 401(k), it will be difficult for you to make other investments, such as buying real estate, as you will lose a good chunk of your gains to this penalty.
There is, however, a small provision in the US Tax Code that allows you to take a distribution from your retirement account and avoid paying the 10% penalty. It is called a 72(t) distribution.
Here is a definition from Investopedia:
Rule 72(t) allows penalty-free withdrawals from IRA accounts and other tax-advantaged retirement accounts like 401(k) and 403(b) plans. It is issued by the Internal Revenue Service. To take advantage of this rule, the owner of the retirement account must take at least five substantially equal periodic payments (SEPPs), and the amount of the payments depend on the owner’s life expectancy as calculated through IRS-approved methods. This rule allows account holders to benefit from their retirement savings before retirement age through early withdrawal without the otherwise-required 10% penalty. The IRS still subjects the withdrawals to account holder’s normal income tax rate.
You can also read more about it on the IRS website here, should you require additional information.
Essentially, there is a way, using your life expectancy and the balances in your retirement account, for you to determine an amount to withdraw each year without having to pay any penalties. You will still pay income tax (there is no way to avoid that), but you will at least avoid paying an additional 10% to the IRS for early withdrawal.
There is a catch though, and that is that once you take your first 72(t) distribution, you are now obligated to take distributions in the EXACT amount for at least 5 consecutive years. If you deviate from this, the IRS can come after you for the 10% penalty on any payments taken prior to that. Therefore, you must be diligent and ensure that your CPA calculates the correct amount of the distribution (there are calculators that help with this) and then it is up to you to remember to take all the required, subsequent distributions.
So…if you’re looking to get into real estate investing, are finding yourself with very little cash, but do have a good chunk of savings in a retirement account, this could be a great way for you to begin diversifying and moving some of your cash away from traditional retirement accounts and into something more profitable, that you can control, and move one step closer towards financial freedom.
Please note that I am not a Certified Public Accountant and am not giving tax advice here. If you are interested in taking advantage of the 72(t) section of the tax code to withdraw from your retirement account and avoid paying penalties, please consult a CPA in order to ensure that you execute correctly.