Section 72 (t) of the Internal Revenue Code is often touted as the secret to early retirement by brokers and financial advisors at free seminars and free lunches for employees of major corporations with profit-sharing and pension plans and 401(k)s. Presentations are made at upscale hotels and restaurants to induce the employees to retire or cash out their 401(k)s earlier than they might otherwise have done through a fairly unknown loophole that allows you to avoid the IRS penalty for early withdrawal. Employees are also promised that that they can cash in their retirement savings in their 40- 50s, reinvest the money, and live off the proceeds for the rest of their lives. But there is a lot more to early retirement benefits that just avoiding the IRS penalty.
First, what is Section 72 (t)? It is the section of the IRS Code that imposes an additional 10% tax on distributions from qualified retirement plans such as profit-sharing and pension plans, 401K’s and traditional IRAs before the age 59 1/2. The only way to avoid this 10% penalty is if the distributions from your retirement plan “are part of a series of substantially equal periodic payments.” These payments must last for 5 years or until you reach the age 59 ½, whichever is longer. The IRS rule is often used as the hook in the early retirement scheme.
The pitch continues with a well-crafted presentation of charts, graphs and handouts depicting stock market and other investment returns over long periods of time, including a representation that stock market returns have historically been in excess of 10% per year. The financial advisor skips over the fact that for many years, and sometimes for longer periods of time, the actual annual return was far less than 10% per year, and some years investors in the stock market suffered losses. Of course, the broker promises returns in excess of 10% per year because of his or her unique skills and expertise at stock and other investment selection and management. The pitch continues with representations and promises that an employee could safely withdraw 7 to 9% from their retirement savings annually for the rest their life and avoid the IRS penalty. So simple! So tempting!! Who wouldn’t want to take early retirement and go fishing or travel around the world!?!?!?
The primary reason is that the stock market does not always have positive returns in any given year, and there have been many years that stock market returns have been less than 10% per year. Consequently, any withdrawal of funds greater than the actual rate of return in any year actually eats into your retirement savings. This is important because your future investment returns and withdrawals are dependent upon maintaining the original amount of savings to earn income for your future retirement years. And every year that you withdraw more than you earn, the greater the investment return must be on the balance of the retirement savings to continue the retirement distributions.
There are other reasons not to fall for this early retirement pitch, and they include the fact that the overall return promised in excess of 10% per annum based on historical stock market returns is reduced by upfront sales charges, investment management fees, and other fees and expenses associated with opening the new accounts with the pitchman. Further, you will pay taxes at ordinary income rates on every distribution, and so, you will net less than the rate of return promised before incurring those additional investment expenses. Moreover, once you begin the 72 (t) withdrawals you cannot stop them without incurring the penalty on all of the withdrawals you have taken. And so, if you begin the “substantially equal periodic payments” at the age 49, you must take them until you are at least 59 ½, and your investment returns must exceed the amount of your withdrawals for over 10 1/2 years to avoid eating into the principal you saved for retirement after many years of employment, which is close to impossible when you withdraw funds at the rate of 7 to 9% every year. In the end, you may be forced to continue with the withdrawals just to avoid massive penalties, w hich just might destroy your retirement altogether.
The most important of investors’ rights is the right to be informed! This article on Section 72(t) of the Internal Revenue Code is by the Law Offices of Robert Wayne Pearce, P.A. , located in Boca Raton, Florida. For over 40 years, Attorney Pearce has tried, arbitrated, and mediated hundreds of disputes involving complex securities, commodities and investment law issues. The lawyers at our law firm are devoted to protecting investors’ rights throughout the United States and internationally! Please visit our blog, post a comment, call 800-732-2889, or email Mr. Pearce at pearce@rwpearce.com for answers to any of your questions about losses you may have suffered in connection with any early retirement recommendation, Section 72(t) and/or any related matter.
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