Generally, taxable distributions from IRAs, qualified plans or 403(b) accounts are subject to a 10% excise tax (early distribution penalty), if the distribution occurs before the owner reaches age 59 ½. However, there are some circumstances under which this early distribution penalty is waived. One such exception is when distributions are taken in accordance with an IRS approved calculation method under a substantially equal periodic payments (SEPP) program. A SEPP program is also known as a 72(t) program, after the section of the tax code under which it is governed.
General Rules
A SEPP must satisfy certain basic requirements. These include the following:
- The SEPP must continue for five years or until the account owner reaches age 59 ½ , whichever is later
- SEPP amounts must be distributed at least annually (at least once per year) from the retirement account. This means that distributions on a monthly, quarterly or semi-annual basis are also permissible.
- The SEPP must be calculated using an IRS approved formula
Failure to meet these requirements could result in amounts taken under the program being ineligible for the penalty waiver.
IRAs Vs Qualified Plans and 403(b) Arrangements
For IRAs, a SEPP can begin at anytime. However, for qualified plans and 403(b) arrangements, a SEPP can begin only if the owner has been separated from service with the employer that sponsored the plan.
Notes:
- If an individual separated from service with the employer that sponsored the qualified plan or 403(b) in the year he/she reaches age 55 or later, he/she need not start a SEPP for those assets, as distributions of those amounts are not subject to the early distribution penalty.
- If an individual is a qualified public safety employee who separates from service after reaching age 50, the 10-percent early distribution penalty does not apply to distributions that the individual takes from a governmental defined benefit pension. An individual is considered a qualified public safety employee if he/she is an employee of a State or political subdivision of a State, and provides police protection, firefighting services, or emergency medical services for any area within the jurisdiction of the State or political subdivision.
Amounts rolled over from these plans to IRAs are subject to the IRA rules, which means the age 55 and 50 rules mentioned above would no longer apply.
Duration of a SEPP
A SEPP program must be continued for five years or until the account owner reaches age 59 ½, whichever period is longer. For instance, if the SEPP starts at age 50, it must be continued until age 59 ½. If the SEPP starts at age 58, it must be continued for five years. Therefore, careful consideration must be given before starting a SEPP, so as to ensure the individual is not forced into taking distributions for which he/she has no immediate need. SEPPs are ideally suited for individuals who will need the funds for the duration of the SEPP program. An example would be someone with little or no other source of income, and will need the SEPP amount to cover living expenses.
Methods of calculating SEPPs
There are three IRS-pre-approved methods of calculating SEPPs. These are as follows:
- The required minimum distribution (RMD) or life expectancy method. Under this method, the SEPP is calculated similar to an RMD. That is, payments are usually calculated by dividing the account balance, by the individual’s:
- Single life expectancy
- Joint life expectancy ( that of the individual and his/her beneficiary) or
- The life expectancy determined under the uniform life table
Under the RMD method, the SEPP is re-figured each year. However, this is not considered a modification. A modification is an action that would result in a violation and disqualification of the SEPP.
This is unlike the other two methods, where the amount required to be withdrawn under the SEPP for each year is usually calculated only once, and the same amount is withdrawn for each year of the SEPP program.
- The fixed annuitization method. Under the annuitization method, once the amount is calculated the first year, the same amount must be distributed annually for the duration of the SEPP program. As explained in Revenue Ruling 2002-62 “The annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer’s age and continuing for the life of the taxpayer (or the joint lives of the individual and beneficiary).” The annuity factor is derived using the mortality table labeled “Appendix B” in Revenue Ruling 2002-62, along with the interest rate chosen by the retirement account owner and his or her tax professional. See below for information on interest rates
- Fixed amortization method. Similar to the annuitization method, payments under the amortization methods are fixed, based on the amount determined when the SEPP is first calculated. A calculation under the amortization method requires the account balance to be amortized (paid in installments) over the individual’s single life expectancy, joint life expectancy, or the uniform table. The amount is calculated using the interest rate chosen by the individual and his/her tax professional. See below for information on interest rates
Important Note: While the general rule is that amounts calculated under the amortization or annuitization methods must be fixed for the duration of the SEPP, the IRS did grant exceptions by issuing private letter rulings (PLRs), allowing taxpayers to refigure the amount each year under these two methods.
While this may appear to contradict the requirements in revenue ruling 2002-62, which states that such amounts must be fixed, one must consider that a PLR is based on a specific set of facts and circumstances. Further, a PLR cannot be used as guidance or precedence, and can be relied on only by the individual to whom it was issued. A PLR, however, does give a good indication of how the IRS may respond to an issue with similar facts and circumstance. A competent tax professional should be consulted if there is interest in refiguring these amounts.
See PLRs 200432021, 200432024 and 200432023.
Which Calculation Method is Right for You?
When considering a SEPP, it is practical to run a comparison of the three methods, so that it can be determined which will provide the desired amount. Let’s look at an example of how the amounts can differ, depending on the method used.
Example:
User Information:
User Information:
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IRA Holder Date of Birth
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01/01/1960
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Life Expectancy Table
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Uniform
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Beneficiary Date of Birth
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01/01/1965
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Start Year
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2006
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Balance of the IRA
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$100,000.00
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Anticipated Rate of Return for RMD method
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5.7%
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Reasonable Rate of Return
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5.7%
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Distribution Frequency
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Annually
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Looking at the first ten years, the SEPP amounts would be as follows:
Results:
Results:
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Hypothetical Projections by Method |
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Year
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RMD
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Annuity
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Amortization
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2006
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$1,980.20
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$6,349.23
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$6,069.28
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2007
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$2,095.35
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$6,349.23
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$6,069.28
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2008
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$2,217.25
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$6,349.23
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$6,069.28
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2009
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$2,346.29
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$6,349.23
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$6,069.28
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2010
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$2,482.91
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$6,349.23
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$6,069.28
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2011
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$2,627.54
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$6,349.23
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$6,069.28
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2012
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$2,774.44
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$6,349.23
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$6,069.28
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2013
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$2,936.21
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$6,349.23
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$6,069.28
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2014
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$3,107.51
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$6,349.23
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$6,069.28
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2015
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$3,288.89
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$6,349.23
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$6,069.28
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In addition to choosing a method that will produce an amount to be distributed from the account under the SEPP, the individual may also transfer a portion of the balance to another account. This is usually done if the current account balance is too high and a smaller amount is needed to produce the desired amount.
Example:
Tom wants a SEPP of $100,000 per year. But his current IRA balance would result in more than $200,000, even if he used the RMD method. Tom may split his IRA balance into two IRAs, with one of the IRAs holding only the amount deeded to produce the desired SEPP amount.
To determine how much is needed to produce a predetermined SEPP amount, use the reverse calculator at www.72t.net.
Interest Rate
The interest rate used to calculate the SEPP must be ‘reasonable’. For purposes of the SEPP, this means that the interest rate used must be no more than 120% of the of the federal mid-term rate for either of the two months immediately preceding the month in which the SEPP begins. The revenue rulings that contain the federal mid-term rates may be found at http://www.irs.gov/app/picklist/list/federalRates.html .
The interest rate does not affect the amount calculated under the RMD method.
Exceptions that Allows Change without Resulting in Modifications
As explained earlier, a SEPP must continue for the amount determined under the selected formula until the established deadline, in order to avoid a modification. However, there are some exceptions to this rule. These include the following:
- Switching to RMD Method: Individuals who use the amortization or annuitization methods may switch to the RMD method, which produces a lower SEPP amount. This is usually done when the account balance is depleting faster than projected, or when the account balance is at risk of depletion. Once the method has been changed, the SEPP must continue under the RMD method for the duration of the program. Note that the change may not be made from the RMD method to any other method
- Depletion of Account Balance: If the account balance is completely depleted before the end of the SEPP period, then naturally this will result in a cessation of the SEPP. However, as long as one of the IRS approved methods was used to determine the amount withdrawn from the account, this depletion will not be considered a modification.
- Death or Disability: If the individual dies or becomes disabled, the requirement to continue the SEPP is waived. For this purpose, disability is defined as being unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. The IRS may require documented proof of disability
- Divorce: The IRS has issued PLRs, allowing participants to reduce their SEPP amounts, in proportion to amounts they had to give to their spouse or former spouse, under a transfer due to divorce or legal separation agreement. See note on PLRs earlier.
Determining Account Balance Used in Calculation
In order for the SEPP to satisfy regulatory requirements, the balance used in the calculation formula must be determined on a ‘reasonable’ basis. The following example provides an explanation of ‘reasonable’ for this purpose.
In order for the SEPP to satisfy regulatory requirements, the balance used in the calculation formula must be determined on a ‘reasonable’ basis. The following example provides an explanation of ‘reasonable’ for this purpose.
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Example:
John’s IRA is valued on a daily basis. He will be taking his first SEPP on March 31, 2012.
John may use the market value of any date from December 31, 2011 through to March 31, 2012.
For subsequent years, John may also use a balance on any date from December 31 of the previous year, up to March 31 of the year that the calculation is being done.
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If the account is not valued on a daily basis, then a valuation provided during the period maybe used. For instance, if the account is valued on a monthly basis, John may use the monthly valuation for any of the months of December 2011 through to March 2012.
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Caution: Take care not to choose a date that is not reflective of the average account value.
For instance, if the value of a particular stock spiked on one day , resulting in the account balance being unusually higher than the other days, it may not be ‘reasonable’ to use the value for that day to calculate the SEPP
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Certain Other Transactions Allowed in SEPP Account
Once a SEPP program has begun under an account, certain transactions are not allowed. These include the following:
- addition to the account balance other than gains
- nontaxable transfers from the account to another retirement plan,
- rollover of the amount , resulting in the amount being nontaxable.
Note:A transfer is permissible if the transfer does not result in the assets included in the SEPP calculation being commingled with other assets. For instance, if a SEPP is established under an IRA and the owner wants to change the financial institution or investments, it is permissible to transfer that IRA to a different financial institution or other investment and continue the SEPP from the new IRA.
Conclusion
Taking distributions under a SEPP program requires careful planning and implementation. This includes combining or segregating amounts to ensure that the SEPP does not exceed nor fall short of the amount the individual needs to satisfy his/her financial needs. Other sources of income must be considered when determining the required SEPP amount. If an account balance is too large, it might be practical to transfer a portion of the balance necessary to satisfy the SEPP to a separate account. This would allow additional distributions to be taken from the other account if necessary, without modifying the SEPP program. Most importantly, individuals should work with a competent financial planner to design the SEPP program.
