What is the goal behind the 10% penalty early withdrawal rule?

[Fermion]

Digging in to details on setting up a 72(t) plan, I have stumbled across some things that make me wonder what is the goal or purpose behind setting up a penalty for early withdrawal of retirement funds in the first place.

One of the cases I read about was a lady who set up a 72(t) correctly and had her annual payment direct deposited by a custodian to her account. Everything went peachy for a number of years but then her custodian retired and did not direct the person at the company taking over his job to continue her direct deposit, so it missed by a couple of weeks and rolled over into the new year. She had to PAY the IRS $10,000 to issue an opinion that she could make up this money in the new year with the extra payment and not bust the plan.

I had no idea you had to pay the IRS for an opinion (up to $55,000!).

I'm kind of really scared right now of doing anything other than a annual lump sum 72(t) no later than October, so I have two full months to correct any error by Fidelity. I am also wondering what is the goal of punishing someone in their retirement by nearly destroying their retirement via penalties and interest for a totally honest mistake.

 

[zinger1457]

The stated reason behind the 10% penalty is to encourage long term participation in retirement plans. Certainly good to be cautious and have all your ducks in a row when setting up a 72t but the case you listed is probably a very extreme one. Would think in that case the custodian would be liable for any cost associated with their screw up but it also shows not very good planning by having the annual distribution done at the very end of the year with little time to monitor and verify. Don't recall anyone on this board having any problems with their 72t, I had one for 7 years with no issues, did my distributions monthly, payments always made like clockwork. Seriously doubt you'll have any issues with Fidelity.

 

[qwerty3656]

Not to highjack the thread, but I turn 59 1/2 this year AND this year would also be the 5th year of a 72t withdrawal. I'm not sure if I have to do anything with the withdrawal or not?

 

[zinger1457]

Not to highjack the thread, but I turn 59 1/2 this year AND this year would also be the 5th year of a 72t withdrawal. I'm not sure if I have to do anything with the withdrawal or not?

Are you asking if you have to take the withdrawal? I would say yes, should be your final required withdrawal, just treat it like the previous payments and report it on your taxes. Would also need to notify your custodian to stop future payments unless you want them to continue on.

 

[SecondCor521]

@Fermion, 72(t) plans are pretty much always done on traditional IRAs. Traditional IRAs are intended to be used to save for retirement, and they come with tax deductions and tax deferrals to motivate that behavior.

Without the 10% penalty, people could (and probably would) save in their IRAs to get the tax benefits, then just withdraw when they needed the money for a new car, or their kids' braces, or whatever. The government does not want to provide incentives to people to save for retirement and then have people abuse that intent.

The case you describe of the lady getting a PLR sounds unusual. Yes, PLRs can cost a lot of money, and the IRS can take your PLR fee which you pay up front and not even provide a favorable ruling. The lady must have had a rather large SEPP (or very conservative advice from her accountants and lawyers) to make it worth paying the fee. I think most normal people would just make the corrective distribution, file taxes, and only deal with the IRS if they came asking questions after the fact.

Not to highjack the thread, but I turn 59 1/2 this year AND this year would also be the 5th year of a 72t withdrawal. I'm not sure if I have to do anything with the withdrawal or not?

Unless you'd rather pay the penalty, you must follow your SEPP plan exactly until the later of both (a) five years from your first distribution, and (b) the date you turn 59.5. After that date you can do whatever you want.

 

[tulak]

Unless you'd rather pay the penalty, you must follow your SEPP plan exactly until the later of both (a) five years from your first distribution, and (b) the date you turn 59.5. After that date you can do whatever you want.

Just to make sure I understand, if I start a SEPP plan when I’m 58, I have to keep withdrawing based on the plan until I’m 63, otherwise I’ll pay penalties?

I’m hoping to avoid a 72(t) by working until I’m 55 (really 54), so I can access a 401k without penalties. But I am curious to know the details in case I need to use a 72(t).

 

[Walt34]

Without the 10% penalty, people could (and probably would) save in their IRAs to get the tax benefits, then just withdraw when they needed the money for a new car, or their kids' braces, or whatever. The government does not want to provide incentives to people to save for retirement and then have people abuse that intent.

They do that anyway, or want to.

My older sister used to work for a company that handled 401(k) plan administration stuff. She said that she spent hours every month explaining to people that no, you can't take money out of your plan for a down payment on a house, car, or anything else, to pay your Aunt Millie's emergency whatever, or to keep the electricity turned on.

Then they'd get doubly incensed when they found out that not only was there a 10% penalty, they'd have to pay income taxes on it too!

 

[SecondCor521]

Just to make sure I understand, if I start a SEPP plan when I’m 58, I have to keep withdrawing based on the plan until I’m 63, otherwise I’ll pay penalties?

I’m hoping to avoid a 72(t) by working until I’m 55 (really 54), so I can access a 401k without penalties. But I am curious to know the details in case I need to use a 72(t).

Yes. Technically it's 5 years, so if you start on your 58th birthday, you're free from the 72(t) restrictions on your 63rd birthday (or the day after, which I would do just to be safe). If you started at 58.37, I would go until you were 63.37+1day.

But yeah, generally speaking, it's the *longer* of the 5 year period or when you turn 59.5. So someone starting close to 59.5 will have to follow the 72(t) restrictions even after they turn 59.5.

One idea that comes up is IRA splitting. If you want to start a 72(t) close to age 59.5 and also might want to access the IRA for additional purposes, you can split the IRA into two pieces - one that you do 72(t) with, and the other for safety/additional purposes/new car. This is perfectly acceptable.

In fact, you can have any number of IRAs with any number of 72(t) programs going if you want to, and each 72(t) program can have different parameters. Of course the paperwork and attention required makes this impractical beyond a certain point, but it's perfectly fine from an IRS perspective.

 

[SecondCor521]

They do that anyway, or want to.

My older sister used to work for a company that handled 401(k) plan administration stuff. She said that she spent hours every month explaining to people that no, you can't take money out of your plan for a down payment on a house, car, or anything else, to pay your Aunt Millie's emergency whatever, or to keep the electricity turned on.

Then they'd get doubly incensed when they found out that not only was there a 10% penalty, they'd have to pay income taxes on it too!

Indeed. Imagine what it would be like without the penalty.

There are now, as I bet you know, some exceptions to the 10% penalty for what Congress has decided are "good reasons" - house down payments and education are two, I think. The income taxes are generally unavoidable as far as I know (well, except for charitable bequests or QCDs).

 

[tulak]

Thanks SecondCor for the detailed explanation.

If I go the 72(t) route, odds are I’d use multiple IRAs, since I’d need to start one sooner than 54. The idea being I’d use a minimal base amount earlier than 54 and then supplement it later based on the size of existing IRAs for extra funds. But hopefully I don’t burn out before 54 to get easy access to the 401k.

 

[Koolau]

I am also wondering what is the goal of punishing someone in their retirement by nearly destroying their retirement via penalties and interest for a totally honest mistake.

Keep in mind that the j*b of the IRS is to collect money from tax payers - not deal with their mistakes. Crushing a few tax payers occasionally keeps the rest of us in line - but YMMV.

 

[Midpack]

Without the 10% penalty, people could (and probably would) save in their IRAs to get the tax benefits, then just withdraw when they needed the money for a new car, or their kids' braces, or whatever. The government does not want to provide incentives to people to save for retirement and then have people abuse that intent.

Exactly.

They do that anyway, or want to.

My older sister used to work for a company that handled 401(k) plan administration stuff. She said that she spent hours every month explaining to people that no, you can't take money out of your plan for a down payment on a house, car, or anything else, to pay your Aunt Millie's emergency whatever, or to keep the electricity turned on.

Then they'd get doubly incensed when they found out that not only was there a 10% penalty, they'd have to pay income taxes on it too!

Same here. I had employees who’d save in their 401k for a couple months, or a few years sometimes, but ultimately pulled the money for one reason or another. Might be a true emergency, might be a vacation or new car. Always made at us when they got hit with the penalty even though we warned them annually or more often. Stupid…

 

[Koolau]

Same here. I had employees who’d save in their 401k for a couple months, or a few years sometimes, but ultimately pulled the money for one reason or another. Might be a true emergency, might be a vacation or new car. Always made at us when they got hit with the penalty even though we warned them annually or more often. Stupid…

BFF who is half a mil in debt at 78 always did this. He DID understand that pulling his 401(k) money involved paying taxes AND penalties. He did it anyway. He could never put off his desires for "stuff" and experiences. When he retired, he was so proud that he had finally let his 401(k) build up to (wait for it) $21K! He spent it within one year of retirement AND all taxes and penalties still applied since he was barely 51 when he FIRE'd.

True enough, BFF has (and had) more toys than I have. But MOST of the 100s of toys he bought over the years are all gone. I'm guessing he has owned two dozen motorcycles, 6 boats, 100 cars/trucks, 10 race cars, 5 RVs, six 4 wheelers, half a dozen wave runners, on and on.

IIRC I've had 13 or 14 cars in 60 years.

Oh, and my 401(k) is bigger than when I retired 17 years ago. BFF's 401(k) is just a distant memory though we had fairly similar incomes from same megacorp. YMMV

 

[scrabbler1]

I didn't learn of this exception until tax time, but in late 2008 when I cashed out the company stock in my 401k plan, using NUA (Net Unrealized Appreciation), only the par value of the stock was subject to the 10% penalty and taxed as ordinary income. The appreciated value (NUA) of the stock was taxed at the maximum cap gains rate at the time (15%). With my company stock, about 97% of its value was NUA and got taxed at only 15%. The 10% tax penalty I paid was just under $1,000, a relatively trivial amount.

This unexpected tax savings of about $30k had me letting out a big yell in delight upon seeing this when I was preparing my 208 income taxes.

 

[Sue J]

I worked for H&R Block in 2008-2010. In my first year a customer walked in and was assigned to me because everyone else was busy. The first thing she told me is that she had been taking early periodic payments from her IRA or 401K but had a situation where she needed to help her daughter last year and she withdrew a lot of money over what she was supposed to withdraw. She knew she'd have major penalties and needed that figured out when she filed her taxes.

From reading on this forum, I expected that she had a 72t and had broken the rules for it and would have penalties. I also knew this was way above my level of training. So I asked around the office. No one had any idea what I was talking about. They never heard of SEPP or 72t. Even the long time tax preparers could not help. So I referred her to another office after checking with them that they had someone who could properly help her.