There’s usually a 10% early withdrawal penalty if you take money from a traditional retirement account in your 50s or younger, but there are a few exceptions to the penalty. A substantially equal periodic payment is a series of retirement account withdrawals that allow account owners to take funds out before age 59 1/2 with no penalty.
A substantially equal periodic payment:
— Enables a retirement saver to withdraw retirement account funds early without incurring a penalty.
— An IRS formula determines how much cash is taken out via a SEPP every year.
— SEPP recipients should be in it for the long haul, as leaving the plan early leaves them vulnerable to onerous penalties.
— If your career is derailed early, a SEPP can cover the income gaps until your finances stabilize.
— An improperly managed SEPP strategy could cause recipients to drain their retirement accounts too soon.
— Don’t go forward with a SEPP campaign without consulting an experienced retirement planning specialist.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
What Is a Substantially Equal Periodic Payment?
Taking money out of retirement accounts early using substantially equal periodic payments allows recipients to avoid the 10% early withdrawal penalty that is typically triggered by early retirement plan withdrawals. “It’s really a matter of establishing a withdrawal plan from your individual retirement account or other qualified retirement accounts before age 59 1/2,” says John Shrewsbury, a financial advisor and co-owner of GenWealth Financial Advisors in Bryant, Arkansas. “Generally, withdrawals prior to that age are subject to a 10% penalty for early withdrawal.”
That scenario is spelled out under IRS code 72(t), where individuals can access cash from a qualified plan without penalty as long as the prescribed rules for substantially equal periodic payments are followed. “However, the rules for this type of withdrawal are both rigid and complex,” Shrewsbury says. “Violate those rules and you could find yourself owing the 10% penalty plus the ordinary income taxes that would be due on the withdrawals.”
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
How to Calculate SEPP Withdrawals
Calculating SEPP withdrawals is based on a complex IRS formula. The amount of the withdrawals depends on the account balance, your age and a divisor published by the IRS which is derived from average life expectancy tables. “There’s also a factor called a ‘reasonable interest rate’ which is published by the IRS,” Shrewsbury notes. “Additionally, the IRS gives you a choice of using a required minimum distribution, fixed annuitization or fixed amortization method of taking the distributions.”
The SEPP retirement plan withdrawal methods include:
Required minimum distributions.Required minimum distributions are calculated by dividing your account balance by an IRS estimate of life expectancy. “In general, the account balance is divided by a life expectancy factor resulting in a payment which changes year to year,” says Joe Di Gangi, president of the Society of Settlement Planners in Easton, Pennsylvania.
Fixed amortization method. Payment under this method is determined using an IRS-approved interest rate and a life expectancy table. “The dollar amount remains the same in each subsequent year,” Di Gangi says.
Fixed annuitization. An annuity factor based on the age of the recipient of the distribution is used to calculate the withdrawal amounts. “The payment remains the same in each subsequent year,” Di Gangi says.
For example, let’s say a 50-year-old has $100,000 in an IRA and uses the “reasonable interest rate” of 2.36% as prescribed by the IRS and the “uniform lifetime table” for their calculation. “In that scenario, the retirement saver could withdraw as little as $2,151 per year or as much as $4,280 per year from their IRA during the SEPP period,” Shrewsbury says.
Another issue is that withdrawals must continue for a minimum of five years or until the IRA owner turns 59 1/2, whichever is longer. “Any variation on the withdrawal, regardless of circumstances, will result in the 10% penalty being imposed on all the withdrawals taken during the SEPP period,” Shrewsbury says.
Pros of Substantially Equal Periodic Payments
SEPPs allow people to access their retirement accounts early without penalty. “This can be advantageous if you want to create extra cash flow for expenses like college payments, home improvements or early retirement,” says Doug Amis, a certified financial planner and owner at Cardinal Retirement Planning Inc. in Durham, North Carolina. “With proper planning, you can subdivide your IRAs and start a SEPP on only part of your retirement funds.”
Cons of Substantially Equal Periodic Payments
Making an error in calculations or timing withdrawals incorrectly can be costly. “These mistakes can cause you to owe penalties on all your SEPP distributions, and not just your most recent year,” Amis says.
The threat of penalties if the program is not strictly followed can be stress-inducing, which is why retirement investors should seek professional help when setting up SEPPs. “We would advise you to never try to do this on your own,” Shrewsbury says. “Consult a tax advisor or financial advisor for assistance. Even then, be very meticulous about following all the rules.”
Once established, there is little flexibility in changing the distribution amount. “You’re afforded a one-time opportunity to switch distribution methods from one of the fixed methods to a required minimum distribution,” Shrewsbury says. “Other than that, you’re locked in for the five-year, age 59 1/2 time period. The methodology doesn’t allow for random withdrawals from your IRA to cover big, unexpected expenses.”
How to Tell if a SEPP Strategy is Right for You
Any decision to go forward with a SEPP strategy should only be made after consultation with a trusted investment advisor or accountant. “A SEPP can be a strategy for early retirement if all the conditions are right,” Shrewsbury says. “Consider whether you have other accounts that you can access to supplement income or to provide additional income during your retirement period.”
Another major consideration is the drain that early retirement places on your IRA funds. “You should ask the question: Does this simply address a short-term need to the detriment of my long-term financial security?” Shrewsbury notes.
SEPPs can be a major risk if executed improperly. “We had a prospective client approach us in 2007 after starting a SEPP program when she left her employer in 2000 and had $1.3 million in her retirement plan,” Shrewsbury says. “Due to the volatility of the market during that time and due to an aggressive SEPP calculation, by 2007 her account balance was down to $300,000. ”
The client was 57 and was required to continue to take distributions until she was 59 1/2 under the plan. “We had to tell her that she was on her way to running out of money around age 60 and would have to think about going back to work,” Shrewsbury says. “That was certainly not the outcome she had desired when she retired, but she thought she was fine because the numbers seemed to work.”
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What Is a Substantially Equal Periodic Payment (SEPP)? originally appeared on usnews.com
