Don't Get Stung With Early Distribution Penalties

To discourage investors from tapping their retirement funds, the Internal Revenue Service (IRS) imposes a 10% penalty on early withdrawals. This penalty applies to 401(k) plans, 403(b) plans and individual retirement accounts (IRA) for any person who has yet to reach the age of 59½. 

But sometimes unexpected financial hardship may force you to withdraw assets prematurely. And there are exceptions to the 10% early distribution penalty. One exception is taking withdrawals under a substantially equal periodic payment (SEEP) program.

SEPP withdrawals are not permitted under a qualified retirement plan if you are still working for your employer. However, if the funds are coming from an IRA, you may start SEPP withdrawals at any time.

When to Use a SEPP

If your financial need is short term, consider whether SEPP withdrawals are right for you. Once starting SEPP payments, you must continue for a minimum of five years, or until you reach the age of 59½, whichever comes later. If you fail to meet this requirement the 10% early penalty still applies, plus you'll owe interest.

Consider the example of Jane, who is 35 years old. After starting SEPP withdrawals, she will be required to continue making withdrawals for the next 24½ years, when she reaches 59½. For Jane, age 59½ comes after five years.

Another example is Harry, who starts his SEPP program at age 57. For Harry, the earliest he can end his program is at the age of 62. For Harry, five years come after he reaches 59½.

If you terminate your SEPP prematurely, you will owe the 10% penalty on amounts taken under the program, plus interest. The IRS allows an exception to this rule for taxpayers who die or become disabled.

Ways to Calculate SEPP

The IRS provides three methods to calculate SEPP withdrawals. Because the three calculations result in different sums, you can choose the one that better suits your financial needs.

Amortization Method

Under the amortization method, the annual payment, which is the same for each year of the program, is determined by using the life expectancy of the taxpayer and his or her beneficiary, if the taxpayer has one, and a chosen interest rate.

Annuitization Method

Similar to the amortization method, the amount under the annuitization method is the same each year. The sum is determined by using an annuity based on the taxpayer's age and the age of the beneficiary, if applicable, and a chosen interest rate. The annuity factor is derived using an IRS-provided mortality table.

Required Minimum Distribution (RMD) Method

Using the required minimum distribution (RMD) method, the annual payment for each year is determined by dividing the account balance by the life expectancy factor of the taxpayer and beneficiary, if applicable. The annual withdrawal amount must be re-calculated each year and, as a result, will change year to year. This method takes into account market fluctuations which impact the account's balance.

Let's take a look at an example that demonstrates the amounts that result from each calculation method.

Suppose that John is 45 years old. He has $500,000 in a retirement account and wants to start SEPP withdrawals. For the amortization and annuitization methods, he will use an interest rate of 3.98%. He has no beneficiary for his IRA, so he will use only his life expectancy. The results are as follows:

  • Amortization method: $25,511.57 per year
  • Annuitization method: $25,227.04 per year
  • Minimum distribution method: $12,886.60 per year

John's financial need will determine his choice of method. John does have the option of transferring a portion of his IRA to a separate IRA account and calculating the SEPP based on what remains. This is usually done for taxpayers who want to leave something for later. For example, if $200,000 is sufficient to cover John's needs, he can transfer the sum to a separate IRA and take the SEPP withdrawals from that IRA account.

IRS Changes and Explanations

Before 2002, some taxpayers who chose the annuitization or amortization methods found their retirement account balances were being depleted faster than projected. This was because the performance of their investments did not keep pace with their withdrawals.

Under the old rules, you were required to stick to the calculation method chosen at the beginning of your SEPP program, despite the possibility of running out of funds. This changed in 2002, when the IRS issued a new rule that allowed taxpayers to make a one-time switch. If you started using the annuitization or amortization methods, you could switch to the RMD method and thus lower your SEPP withdrawals.

If you are already on a SEPP program using the amortization or annuitization method and want to change to the RMD method, consult with your financial professional.

Life Expectancy Tables

The three life expectancy tables that may be used to calculate SEPP payments are: the single life expectancy table, the uniform lifetime table, and the joint and last survivor table. Generally, your choice of table is determined by whether you have designated a beneficiary of your retirement account. Your financial professional should be able to assist you in choosing the right table.

If you are using the joint and last survivor life expectancy table to calculate your SEPP, your beneficiary is determined on January 1. Therefore, if you changed your beneficiary during the year, be sure to inform your financial professional so that he or she can use the right life expectancies.

Also, if you have multiple beneficiaries, the oldest beneficiary's life expectancy is used to calculate your SEPP.

How to Treat a Beneficiary Change

To calculate your SEPP payment for the year, you will use the life expectancy of the beneficiary who was on your retirement account as of January 1 of the year for which the calculation is being done. Any change made after January 1 is taken into consideration the following year, provided the change is still in effect at the beginning of that year.

Dealing with Interest Changes

Each month the IRS issues a revenue ruling in which certain interest rates are provided. One such rate is the federal mid-term rate. According to Revenue Ruling-2002-62, a taxpayer should use a rate of up to 120% of the federal mid-term rate to calculate SEPP amounts under the amortization and annuitization methods.

No Additions or Subtractions Allowed

Once you start a SEPP program on a retirement account, you may not make any additions to or distributions from the account. Any changes to the account balance, with the exception of the SEPPs and required fees, such as trade and administrative fees, may result in a modification of the SEPP program and could be cause for disqualification by the IRS. As explained earlier, any disqualification will result in an assessment of penalties and interest.

Account Balance

The IRS guidelines for determining the account balance to use in the SEPP program provide much flexibility. Should you decide to change the calculation method for your existing SEPP or start a new SEPP program, be sure to consult with your tax professional regarding the account balance that should be used in the calculation. As with any issue pertaining to retirement plans, you must be sure to seek competent tax-professional assistance to ensure that you operate within the parameters of the regulations.

The Bottom Line

Taxpayers often make costly mistakes with SEPP programs because there is little guidance on what can be done in certain situations. In cases where guidance is needed, consider working with a tax professional who has experience dealing with the IRS on SEPP issues. A few of these individuals have been able to convince the IRS not to assess penalties, where they would otherwise apply.