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How a Little-Used IRS Withdrawal Rule Could Potentially Help You Increase Roth Conversions

How a Little-Used IRS Withdrawal Rule Could Potentially Help You Increase Roth Conversions

April 04, 2022

Rule 72(t) of the Internal Revenue Code outlines the process for making early withdrawals from a qualified retirement account such as a 401K or an IRA without paying a 10% penalty. While it's certainly kind for our government to offer a nonpenalized way to pay taxes early, there are occasions where it can make reasonable planning sense to do so. With U.S. Tax rates at a historic low point, this may indeed be one of those times.

Wait a second! I thought deferring taxes was beneficial for my future. 

From an early age, most of us have probably been taught that saving and deferring taxes as long as possible was the right approach for retirement planning. Just keep saving consistently, diversify, and your retirement nest egg will be there with enough time. While I'm certainly not discouraging saving, the value of deferring liabilities should be scrutinized in the same way we evaluate any other personal debt. Any investment growth experienced in a qualified plan will also come with corresponding growth in liabilities owed to the government, so a better question might be: What is the deferral's current value? 

The Tax Cuts and Jobs Act of 2017 (TCJA) lowered the income tax brackets for almost every taxpayer. In most cases, the bracket change was a 15% reduction, which lowered the effective taxation (the blended rate assessed to a taxpayer) that people pay in taxes. Yet, without congressional action, the TCJA is scheduled to expire in 2025 and revert to the older and, in many cases, higher tax brackets for taxpayers. This also assumes that Congress does not create any new taxes along the way for "high income" earners. 

With our national debt now well over 30 trillion dollars, math tells us that the debt must be addressed at some point, and those who have put themselves in a position to earn more will be asked to pay their "fair share" to address the shortfall. 

So how exactly does Rule 72(t) help tax advantage of the current tax climate? The idea of having a large Roth IRA in retirement for income distributions would be a welcome outcome for anyone. Doing an IRA conversion, though, is not a free lunch. Taxes must be paid. Most people during their working years lack the resources to do more than modest conversions each year, or it could undermine the other valuable savings and planning work they are doing. 

In a low tax environment, though, a creative solution for paying taxes may be to take additional money from an existing IRA using rule 72(t) 's substantially equal periodic payments (SEPP) penalty exception and make larger conversions each year before 59 ½. 

How does a SEPP work, and why should it merit consideration in my planning? There are very specific guidelines to follow when using a SEPP exception under rule 72(t). Payments must be consistent, continuous, and calculated using approved tables and distribution methods from the IRS. It is crucial to follow these rules and seek guidance from a qualified professional because a single missed payment or misstep could trigger expensive penalties for noncompliance. This rule only applies to IRAs not affiliated with a current employer. 

If you believe that taxes will be higher in the future at all earning levels or would like more time to grow your IRA on an after-tax basis, it may make sense to evaluate the use of a SEPP plan while we have a few more years of the current tax environment. The IRS is not in the habit of advertising tax sales, but if you’re  paying less tax than you have historically then this sale could very well apply to you