What Does Substantially Equal Periodic Payment Mean?
A substantially equal periodic payment plan allows individuals who have invested in an IRA or another qualified retirement plan to withdraw funds prior to the age of 59 1/2 and avoid income tax and early withdrawal penalties. Typically, an individual who removes assets from a plan prior to age 59 1/2 will face taxes on that withdrawal and a 10% penalty. With substantially equal periodic payments, the funds are placed into a SEPP plan that pays the individual annual distributions for five years or until turning 59 1/2, whichever comes later.
Because the IRS requires individuals to continue the SEPP plan for a minimum of five years, this is not a solution for those who seek penalty-free short-term access to retirement funds. If you cancel the plan before the minimum holding period expires, you will have to pay the IRS all the penalties that were waived on amounts taken under the program, plus interest. SEPP plans are also permitted with money from employer-sponsored qualified plans, such as 401(k)s, but you cannot currently work for the employer that sponsored the plan.
There are three IRS-approved methods used to calculate SEPPs – amortization, annuitization, and required minimum distribution – and each one results in a different calculated amount. The IRS advises individuals to select the method that bests supports his or her financial situation.
Required Minimum Distribution and SEPP
This method is used with a life expectancy – single life or uniform life or joint life and last survivor each using attained age(s) in the distribution calculation year – and an account balance. Then, the annual payment is redetermined annually.
Fixed Amortization Method and SEPP
This method consists of an account balance amortized "over a specified number of years equal to life expectancy (single life uniform life or joint life and last survivor) and an interest rate of not more than 120% of the federal mid-term rate," according to the IRS. When a yearly distribution amount is calculated using the fixed-amortization method, then, the identical dollar amount must be distributed each year moving forward.
SEPP and Fixed Annuitization
The IRS explains that "the fixed annuitization method consists of an account balance, an annuity factor and an annual payment. The annuity factor is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and an interest rate of not more than 120% of the federal mid-term rate." It is important to note that when using this method to calculate an annual distribution, like with the fixed-amortization method, the identical dollar amount must be distributed in the following years.
Experts warn that taxpayers run the risk of making costly mistakes when working with SEPP plans due to lack of guidance and rules.