72T (SEPP) distributions with a Roth IRA

Submitted by Doug Stecklein on Fri, 2020-01-17 02:50

I have been putting 100% of my savings in retirement accounts for the last 20 years.
My plan was to semi-retire early (41 now) by using the 72(t) rule.
My “problem” is that 65% of my savings are in both my wife and I’s Roth IRAs.
Tonight I was told that If I were to withdraw from our Roth accounts using 72(t) I would have to pay taxes on the distribution.

Is there a legal way around this?

If I’m only able to use rule 72(t) with my traditional IRAs, simple IRA, and 401k I’m looking at 35% of my total savings, which will not be enough.



Submitted by Alan - IRA critic on Fri, 2020-01-17 03:54

  • Starting a 72t plan at 41 is a recipe for disaster since you would have to continue distributions for 18 years. Eventually, you would probably bust the plan and owe penalty and interest back to day 1. You can tap your regular savings and probably pay little in taxes, perhaps some cap gains taxes, but if no one is working you would probably be in the 0% LT cap gain bracket.
  • You can also tap your Roth using the usual ordering rules. First out are your regular contributions tax and penalty free. Next are conversions starting with the oldest conversions. Conversions over 5 years (done before 2016) also come out tax and penalty free. Conversions under 5 years are subject to the 10% penalty. Last out are your Roth earnings, and only earnings are subject to both tax and penalty. Therefore, whether you use a 72t plan or not, you need to know the composition of both of your Roth IRAs since you will have to report distributions on Form 8606. The main point is that I doubt that most of your Roth IRA balances are earnings, and only the earnings are subject to taxes.
  • While it is possible to use both your TIRA and Roth IRA combined in a plan, these are very rare and the IRS does not understand them very well. Any error and the plan is busted. But if you started such a plan, the 10% penalty on withdrawals of conversions under 5 years and on earnings would be waived by the 72t plan exception. If your spouse wants to use her accounts, that would have to be a separate plan as you cannot combine both spouses IRAs into a single plan. 
  • For 72t plans, it is best to keep it simple so the IRS will understand what you are doing and you do not make an error. Also, as indicated these plans are best used at age 50 or over since they are so inflexible. If you start with your non IRA savings, you can cut down the length of your plan. Also, you said “Semi retire” so you apparently will be able to bring in some earnings to reduce the amount you need from these plans. It is a bad idea to spend down your retirement savings before you even get to the usual retirement years. Health insurance can also be very expensive without an employer plan. If you have high healthcare costs you can tap your TIRA without penalty to the extent those unreimbursed costs exceed 7.5% or 10% of your AGI depending on what threshold the politicians adopt.

 

Submitted by Doug Stecklein on Fri, 2020-01-17 20:28

Hi Alan, Thank you for the thorough response!  

  • I am self employed, have been for 20 years, so i have become accustomed to paying my own health insurance.  I am in the construction industry so I need to start supplementing my income with retirement savings so I can wind down my business and have less stress on my body.  
  • I do not have any significant savings besides what is in my retirement accounts.  My retirement savings are around 20 times my annual income so I am confident, especially with investment income considered, that I will not drain my accounts by taking 2.5% RMD SEPP payments every year.  I am reluctant to give out numbers online, I hope percentages will suffice.
  • Percentage of total Retirement savings:

My Roth IRA – 54%        Wife Roth – 10%      Solo 401k- 20%       Simple IRA- 16%                                                              Only about 12% of the balances are contributions.  88% are earnings.

  • I am interested in hearing more about combining a TIRA and Roth IRA account for SEPP purposes.

Could I do this with my Roth, Solo 401k, and Simple IRA to increase the balance used in determining my SEPP payments but only make the withdrawals from the non-Roth accounts?I would most likely withdraw my Roth contributions before starting any SEPP plan.

Submitted by Alan - IRA critic on Sat, 2020-01-18 04:08

  • While the IRS Regs state that an IRA under a 72t plan can be converted to a Roth IRA during the plan, it does not clearly state that a 72t plan can be established using both types of IRAs from the start. Therefore, without specific guidance, one cannot be sure that the IRS will approve such a setup. That same Reg also contemplates conversion of the entire IRA to a Roth IRA, not part of it. That would leave only one type of IRA in existence at any point in time under the plan. So no certainty to the combined structure at the time of plan setup. That does not mean that you couldn’t have two 72t plans running side by side, one from TIRA and the other from the Roth, but that does not provide the same flexibility of choosing which IRA to take the distributions from. With two plans, you have to take 72t distributions from both of them.
  • Spouse’s plan would face the same issues separately.
  • It is not clear whether you intend to continue the solo K or the SIMPLE IRA during this period. You cannot have a 72t plan using an on going SIMPLE IRA since it will be receiving contributions. You would probably roll one or the other of those two plans into a TIRA used for the 72t plan. 
  • Current low interest rates produce a payout of roughly 4.5% of the account balance. If you only need 2.5% then you would partition the IRA(s) into accounts about 55% of the total retirement balance. The other 45% would be left outside the plans for emergency needs or to start an additional 72t plan later on once it becomes clear that inflation or living expense patterns will require consistent additional distributions. 
  • If you withdraw most of the Roth regular contributions prior to starting a plan including the Roth, you can delay the start of the 72t plan. Again, if you have conversions under 5 years that must be distributed you will owe the 10% penalty unless the distributions fall under a 72t plan to waive the penalty.

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