As one would expect, 72(t) is named after a section of the Internal Revenue Code. It deals with substantially equal periodic payments and how they can be used to avoid the 10% early withdrawal penalty in Individual Retirement Arrangements (IRAs) and employer sponsored defined contribution plans (such as the Thrift Savings Plan).
A 10% early withdrawal penalty will apply to any post separation withdrawals from the TSP that are taken before the year in which you reach the age of 55. For certain special category employees (law enforcement officers, firefighters, CBPOs, air traffic controllers, Supreme Court and Capitol police officers, nuclear materials couriers and DSS special agents in the Department of State), the age is 50 – not 55.
The penalty also applies to anything you withdraw from an IRA before you reach 59 ½ (not the year in which you reach 59 ½, but the actual day you reach 59 ½) regardless of your employment status.
If you take substantially equal periodic payments following rule 72(t) for whichever is longer, five years or until you reach the age of 59 ½, you are exempt from the 10% early withdrawal penalty. So, a regular employee could separate from federal service under a VERA at the age of 53 and avoid the early withdrawal penalty on TSP withdrawals by following Rule 72(t) until reaching 59 ½. In fact, the Thrift Savings Plan has a withdrawal choice that is designed for just such a person; it’s called installment payments following the IRS life expectancy table. By choosing that withdrawal option a person is effectively electing substantially equal periodic payments and will not face the penalty. It makes no difference whether they elect monthly, quarterly or annual installment payments.
BUT – if the above employee were to stray from this withdrawal choice, either by switching to installment payments of a fixed dollar amount, or by taking an additional partial withdrawal (now allowed due to the TSP Modernization Act), that person would end up owing early withdrawal penalties retroactively all the way back to when they began their withdrawals. You’ve got to be careful to follow 72(t) to the letter if you’re going to use it to avoid the early withdrawal penalty.
If you’re considering taking substantially equal periodic payments from an IRA, coordinate your payments with the IRA custodian.
There’s another group of retirees for whom a life expectancy based withdrawal makes sense – those age 72 and older who are required to take minimum distributions (RMDs) from the TSP and from IRAs. The penalty for failing to take a RMD is 50% of the missed RMD. If you’re required to take out $12,000 per year and only take out $9,000, your penalty would be $1,500 (half of the $3,000 you should have taken but didn’t). If your IRA custodian sets up substantially equal periodic payments, you will take out exactly the required amount and will not be subject to the 50% penalty. The TSP has rules in place that will always protect you from the penalty. If, following your final payment of the year (December for those taking monthly installment payments), you have not taken out the full amount of your RMD, the TSP will send you an additional payment of the amount necessary to meet your RMD.
But Wait, There’s More! There’s one more thing that you need to watch out for if you’re taking life expectancy table based payments from the TSP. The TSP’s infamous “tax trap”. Withdrawals from your traditional TSP are fully taxable at your rate for ordinary income, yet here’s what the TSP says about withholding from life expectancy based payments: “We’re required to withhold for federal taxes from any taxable amount as if you are married with three dependents unless you elect a different option.” This withholding rate is almost certainly too low to cover the taxes owed on your TSP payments. You better elect a different withholding rate or you will have a nasty surprise at tax time.
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