By Denise Appleby
Because the funding vehicle for an SEP is a Traditional IRA, the distributions rules of a Traditional IRA also apply to SEP IRA assets.
Traditional IRA Distributions
Distributions from Traditional IRAs must occur eventually, but some distributions are elective while others are mandatory. The tax and penalty applied to distributions from a Traditional IRA depend on the IRA owner's age at the time of the distribution and the tax-deductibility treatment of the assets at the time of their contribution.
Distributions That Occur Before Age 59.5
Most taxpayers intend to retain assets in their IRA until their retirement years, but, for varying reasons, people are sometimes forced to distribute assets before these years. Distributions that occur before the IRA owner reaches the age of 59.5 are subject to a 10% early-distribution penalty, in addition to any income tax; the IRS will waive this early-distribution penalty when distributions are used for certain reasons. These include the following:
For Unreimbursed Medical Expenses
If the distribution is used to pay unreimbursed medical expenses, the amount that exceeds 7.5% ( 10% after 2012) of the individual's adjusted gross income (AGI) for the year of the distribution will not be subjected to the early-distribution penalty. In other words, the amount paid for the unreimbursed medical expenses minus 7.5% of the individual's adjusted gross income for the year of the distribution can be distributed penalty free.
Example: Using SEP Funds for Medical Expenses
Jack\'s AGI is $25,000, and he paid $4,000 for unreimbursed medical expenses.
The amount that exceeds 7.5% of his income = $4,000 - ($25,000 x 7.5%).
The amount that exceeds 7.5% of his income = $4,000 - $1875.
The amount that exceeds 7.5% of his income = $2,125.
The maximum amount Jack may claim for the early-distribution exception is $2,125.
To Pay Medical Insurance
Individuals can make a penalty-free distribution to pay medical insurance for themselves, their spouses and their dependents provided the distribution occurs under the following four conditions:
- The individual has lost his or her job.
- The individual has received unemployment compensation paid under any federal or state law for 12 consecutive weeks.
- The individual receives the distributions during either the year he or she receives the unemployment compensation or the following year.
- The individual receives the distributions no later than 60 days after he or she has been reemployed.
For a Disability
If an individual becomes disabled before age 59.5 and makes a distribution from his or her Traditional IRA because of the disability, the distributions are not subject to the early-distribution penalty. Individuals are considered disabled if they furnish proof that a physical or mental condition inhibits them from engaging in substantial gainful activities. A physician must determine that this condition can be expected to result in death or to continue for an indefinite duration.
As Distributions to the IRA's Beneficiary
If the IRA owner dies before reaching age 59.5, the amounts distributed from the IRA by the designated beneficiary are not subject to penalty.
As Part of an SEPP Program
For penalty-free distributions that are part of a series of substantially equal payments over the life of the IRA holder and or his or her beneficiary, the payments must last five years or until the IRA owner reaches age 59.5 - whichever is longer - and the payments must also follow certain IRS-approved methods.
For Qualified Higher Education Expenses
Amounts are penalty free if they must go toward qualified higher education expenses for the IRA owner and/or his or her dependents. These qualified education expenses include tuition, fees, books, supplies and equipment required for the enrollment or attendance of a student at an eligible educational institution. An eligible educational institution is any college, university, vocational school or other post-secondary educational institution eligible to participate in the student aid programs administered by the Department of Education. These eligible educational institutions include virtually all accredited post-secondary institutions, whether public, nonprofit or proprietary (privately owned and profit making). The educational institution should be able to indicate whether it is an eligible educational institution.
To Purchase a First Home
The IRA owner can make penalty-free distributions to purchase, build or rebuild a first home:
- For the IRA owner
- For the IRA owner's spouse
- For a child of the IRA owner or of the IRA owner's spouse
- For a grandchild of the IRA owner or of the IRA owner's spouse
- For a parent or other ancestor of the IRA owner or of the IRA owner's spouse
The first-time homebuyer distribution must be used to pay qualified acquisition costs before the end of the 120th day after the IRA owner receives the distributed assets.
The total distribution the IRA owner uses for first-time home purchases cannot exceed $10,000 during the IRA owner's lifetime. For married individuals, the $10,000 applies separately to each spouse, which means that the total for both is $20,000.
For Payment of an IRS Levy
The IRS may levy against an IRA, resulting in a distribution. The distributed amount is subjected to income tax, but the early-distribution penalty is waived.
The 10% early-distribution penalty does not apply to amounts that are not subject to income tax. These amounts include the following:
- Distributions of nondeductible IRA contributions
- Amounts that were in excess of the contribution limit and are then removed from the IRA before the IRA owner's tax-filing deadline (plus tax-filing extensions)
- Distributions that within 60 days of receipt are deposited to a retirement plan as a rollover contributions
Distributions That Occur on or After Age 59.5
Distributions that occur on or after the IRA owner reaches age 59.5 may be subject to income tax but will not be subjected to any early-distribution penalty.
Required Minimum Distributions
IRA distributions cannot be deferred indefinitely. An IRA owner must begin required minimum distributions (RMDs) the year he or she reaches age 70.5, at which time the IRA owner may distribute the full balance of the IRA or distribute a minimum amount each year.
The first RMD must be distributed by April 1 of the year after the IRA owner reaches age 70.5. For example, an IRA owner who reaches age 70.5 in June of 2013, must take his or her first RMD by April 1, 2014. IRA holders must have a minimum amount distributed for each subsequent year by December 31 of each year. This means that if the IRA holder defers the first RMD until April 1 of the year after he or she turns 70.5, the IRA holder will be required to take a second RMD amount in that same year, which counts as the second year for RMDs.
Example: RMD Distribution Rules
Jill turns 70.5 in June of 2012, and she decides to defer her first RMD until April 1, 2013.
Jill is required to take a second RMD (for 2013) by December 31, 2013. For subsequent years, Jill must distribute her RMD amounts by December 31 of each year.
Generally, the IRA custodian/trustee will calculate the RMD amount and send the notification to the IRA holder. Alternatively, the IRS custodian/trustee may send an RMD reminder to the IRA holder with an offer to calculate the RMD amount upon request.
RMD amounts not distributed from the IRA by the due date are subject to a 50% excess-accumulation penalty.
Example: The Excess Accumulation Penalty
John is 75 years old, and his RMD for 2013 is $5,000. By December 31, 2013, John has distributed only $4,000. Because John\'s RMD was short by $1,000, he must pay the IRS a 50% excess-accumulation penalty ($1,000 x 50% = $500).
The excess-accumulation penalty must be paid when the individual files his or her federal tax return. If the individual feels that the failure was due to reasonable circumstance, he or she may write to the IRS and request that the penalty be waived. If a waiver is being requested, the penalty is paid only if the IRS responds to say the request is denied.SEP IRAs: Conclusion
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