# Learn the Rules of Substantially Equal Periodic Payment (SEPP)

You can make costly mistakes if you don't follow them

## Don't Get Stung With Early Distribution Penalties

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

However, sometimes unexpected financial hardship may force you to withdraw assets prematurely. In rare instances—and in 2020 due to the pandemic (see box below)—there are exceptions to the 10% early distribution penalty. The exceptions vary based on whether you have a qualified retirement plan sponsored by an employer, such as a 401(k) or 403(b), or an IRA.

### Required Minimum Distribution (RMD) Method

Using the required minimum distribution (RMD) method, the annual payment for each year is determined by dividing the current account balance by the life expectancy factor of the taxpayer. The annual withdrawal amount must be recalculated each year with the new account balance and, as a result, it will change year to year. The life expectancy table chosen in the first year must continue to be used each following year.

It is expected that the amount will change annually. However, it is still considered to be "substantially equal" and acceptable in the SEPP program so long as this method is consistently followed. This method takes into account market fluctuations, which impact the account's balance.

## Example of SEPP Calculations

Let's take a look at an example that demonstrates the annual 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% (assumed to be 120% of the federal mid-term rate) and his single life expectancy of 38.8 years. 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 over the next 14½ years (59½ – 45) that he will be taking SEPP withdrawals will determine his choice of method. He also needs to consider what he expects to need in retirement after the age of 59½.

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

## IRS Changes and Explanations

Before 2002, some taxpayers who chose the fixed 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 fixed annuitization or amortization methods, you could switch to the RMD method and thus lower your SEPP withdrawals. Once this change was made, you had to remain with the RMD method for all subsequent years.

If you are already on a SEPP program using the fixed amortization or annuitization method but 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.

The SECURE Act, passed in December 2019, made changes to the life expectancy tables to account for increases in life expectancies across the board. As a result, if either the fixed amortization or annuitization methods were used, the annual amount can be recalculated once using the new tables without the update being treated as a modification for the SEPP program. This change has the potential to lower the annual amount required under these two methods.

## Beneficiary Changes

If you are using the joint and last survivor life expectancy table to calculate your SEPP, your beneficiary is determined on Jan. 1. 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 Jan. 1 of the year for which the calculation is being done.

Any change made after Jan. 1 is taken into consideration the following year, provided the change is still in effect at the beginning of that year. Therefore, if you changed your beneficiary during the year, be sure to inform your financial professional so that they can use the right life expectancies.

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

## Figuring Interest Rates

Each month the IRS issues a revenue ruling in which certain interest rates are provided. One such interest 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 fixed amortization and annuitization methods. The mid-term rate may be taken from either of the two months immediately leading up to the first distribution.

This maximum allowable rate is a conservative figure for future account earnings. Thus, it is an attempt to ensure the taxpayer does not deplete the account sooner than anticipated.

## 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. This includes any nontaxable rollovers into other retirement accounts. Any changes to the account balance, with the exception of the SEPPs, gains, losses, 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 assistance from a competent tax professional to ensure that you operate within the parameters of IRS regulations.

## The Bottom Line

As always, withdrawing money from a retirement account should be a financial last resort. This is why the IRS has exceptions for specific circumstances like disability and illness. If you do not meet any of the criteria for other exceptions, the SEPP program can be used if you have exhausted all other avenues. It should not be used as an emergency fund strategy, as any withdrawals significantly affect your future financial stability.

Taxpayers often make costly mistakes with SEPP programs because there is little guidance on what can be done in certain situations. In cases where extra guidance is needed, consider working with a tax professional who has experience dealing with the IRS on SEPP issues.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
1. Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions From Retirement Plans Other Than IRAs."

2. Internal Revenue Service. "Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers."

3. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

4. Congress.gov. "H.R.748 - CARES Act."

5. Internal Revenue Service. "Substantially Equal Periodic Payments."

6. Internal Revenue Service. "Retirement Plans FAQs Regarding Substantially Equal Periodic Payments."

7. Internal Revenue Service. "Revenue Ruling 2002-62," Page 5-6.

8. U.S. Department of the Treasury. "Updated Life Expectancy and Distribution Period Tables Used for Purposes of Determining Minimum Required Distributions."

9. Internal Revenue Service. "Applicable Federal Rates (AFRs) Rulings."

10. Internal Revenue Service. "Revenue Ruling 2002-62," Page 4.

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