Substantially Equal Period Payments, or SEPP, have been with us since the late 1980s. This method is the only way to make discretionary Traditional IRA (TIRA) or Employer Sponsored Retirement Plan (ESRP) taxable withdrawals without a 10% penalty (note: there is one exception to the 10% penalty for discretionary ESRP withdrawals discussed later.) The rules involving the details of setting up and administering the SEPP are complex. Errors can 'bust' the entire plan at any time and with back penalties and interest, can get expensive.
Coming up on early (pre age 59 ½) retirement with most of your retirement savings in your retirement plan including IRA(s)? If so, then you probably need to withdraw from one or more of these savings plan for several years before, say, a pension begins or you can begin Social Security retirement benefits. The challenge here is the 10% early withdrawal penalty and how to avoid it. To better explain this, here is an example:
Emelia is 52 and married to Chance who is aged 50. Emelia was recently given the option to take an early retirement with a deferred compensation bonus, which she accepted. However, she cannot begin withdrawals from the deferred comp plan until age 60. She is able to roll over her $640,000 qualified profit sharing plan from her employer to her IRA which holds $162,000 of her past year's contributions, $76,000 of which were made after tax (not deducted). Due to the specialized nature of her job, Emelia does not wish to return to work and so plans to retire early. She wants to begin withdrawals of $30,000/year from her Traditional IRA (TIRA) with a current balance of $802,000. However, she is not yet 59 ½ and so will be subject to a 10% penalty on all taxable withdrawals from her TIRA. Based on this need, is there a way she can avoid this 10% penalty? Yes, there is.
Substantially Equal Periodic Payments (SEPP)
The IRS states in IRC 72(t), IRS Notice 89-25 and in the subsequent Revenue Ruling 2002-62, that an individual like Emelia may avoid the 10% early withdrawal if they comply with the following general rules:
The withdraw from their IRA is a stream of Substantially Equal Periodic Payments (SEPP) made at least annually. These payments must be calculated to be paid over the life of the IRA owner or jointly over the lives of the owner and joint spouse. The annuity amount must be withdrawn until the IRA owner attains age 59 ½ and they have taken at least 5 years of withdrawals. Note that BOTH of these conditions must be met. The method of calculating the base amount to be held in the IRA that would otherwise fund a lifetime of substantially equal annual withdrawals and from this, the annual required withdrawal, must be one of the three approved methods outlined in RR 2002-62. Failure to take the annual withdrawal, adding anything to the IRA during the withdrawal period or taking more than the calculated withdrawal amount will result in the entire SEPP being 'busted' which will subject all past taxable withdrawals to the 10% penalty and interest.
Clearly, this provision would be used only by those who are not yet 59 ½ and who need the income from the TIRA. Most of the existing exceptions to the 10% early withdrawal penalty described in IRC 72(t)(1) for IRAs have to do with personal hardships, but the exception for SEPP has to do with IRA withdrawals simply because the IRA owner wishes it. No special need or hardship must be demonstrated. Another unique provision of SEPP is that much of the current provisions governing its establishment and ongoing administration are not from rules established in the tax code, but are from Private Letter Rulings (PLRs) that have no basis in tax law but are instead only the IRS interpretation of the tax code that applies to a specific question for a specific set of circumstances raised by a specific tax payer and so can only really serve as a guide to those considering a similar action with their own IRA. Add to this that there is no established method to correct errors or oversights for a past year's mandatory withdrawals and that such errors or omissions may result in a failure of the entire SEPP unless the IRA owner submits (an expensive) PLR to the IRS to explain why the error occurred and ask forgiveness. The 72(t) SEPP is thus complicated. Careful planning and a strict attention to detail is a prerequisite to utilizing the provisions of the SEPP.
The SEPP may be applied to all forms of tax favored salary deferral plans, as the rules for establishing and administering them are the same. There is a separate provision in IRC 72(t) that allows one to separate from the employer and make withdrawals from the employer's retirement plan and also avoid the 10% penalty, provided the employee is at least age 55 in the year of separation and the retirement plan savings remain IN the plan. However, this rule does not apply to IRAs.
Steps in Establishing and Operating a SEPP
When I was working in the industry, SEPPs were not uncommon and were generally administered by the brokerage firms that were also the IRA custodians. The brokerage would do the calculations, help set up the IRA for the SEPP, do the account valuations and make the monthly (or other period) payments. However, most IRA custodians today will no longer provide this service, but require the IRA owner to do their own calculations, valuations and withdrawals. Therefore, careful planning is the standard.
Step #1: How much annual income does the IRA owner require? Dividing this by .04 to .05, a historic average, will give an approximation to the dollar amount that must be committed to the SEPP that will not be available to the IRA owner while the SEPP is in force. So for Emelia, this would be about $600,000 to $750,000, which is within her total savings. Were the SEPP plan requirement more than the retirement savings, the new retiree would either have to delay retirement, find savings elsewhere or reduce household income need... or... pay the 10% penalty on early withdrawals.
Step #2: Will the IRA custodian do the calculations and set up the periodic required distributions? If not… and most today will not… will require the work be done by the IRA owner or a financial planning professional they hire who is familiar with these rules. This will require a bit of 'shopping' and will require getting estimates on charges to set up such a plan... and these estimated costs compared with just paying the 10% early withdrawal penalty.
Step #3: Set the first distribution month and how often/when subsequent distributions will be taken. It is easiest if one distribution is taken per year and then parsed out as required during the year. More frequent distributions, such as quarterly or monthly, provide greater opportunity for mistakes to be made. But once a distribution schedule is chosen, it should not be modified.
Step #4: Set the account valuation date. RR 2002-62 says "The account balance that is used to determine payments must be determined in a reasonable manner based on the facts and circumstances." Most opinions I've read on this say the valuation date should not be greater than 6 months prior to the first distribution date. To be safe, I recommend using the end of month balance for the month immediately preceding the first withdrawal month or the end of the month 2 months preceding the first withdrawal month, keeping it consistent with the date in Step #5.
Step #5: Set the month for determining the interest rate used in the calculation. This month must be either the month immediately preceding the first distribution month or 2 months immediately preceding the first distribution month. The interest rate that must be used cannot be greater than 120% of the federal mid-term rate. So if Emelia wishes to take her first distribution in August of 2016, the June and July 2016 federal midterm rates are 1.41% and 1.43%, respectively. So 120% of these would be 1.692% and 1.716%, respectively. Using the slightly higher midterm rate for July will give her a slightly higher annual distribution amount.
Step #7: Determine life expectancy. The IRS allows the IRA owner to use one of three life expectancy tables to determine the number of years of life expectancy that must be used in the below calculations to determine the annual distribution amount. They are the Single Life Expectancy Table (Table I), the Joint-Survivor Life Expectancy Table (Table II) or the Uniform Life Expectancy Table (Table III). The first two of these tables can be found in Appendix B of Publication 590-B. The Uniform Table (Table III) in Publication 590-B cannot be used as it begins at age 70, which is of no value to one considering the SEPP option. Instead, I recommend using the Uniform Table III found as an appendix to RR 2002-61.
If the objective of the IRA owner is to draw the highest percent from the IRA as possible, then they will want to use the life expectancy table with the lowest life expectancy, which is usually the Single Life Expectancy (Table I). For Emelia, her life expectancy will be 32.3 year, 39.5 years and 44.6 years from tables I, II and III, respectively, with a husband aged 50. If she must recalculate the annual required distribution each year, she will 're-enter' the same life expectancy table each year of the SEPP's existence.
BREAK! Let's talk about using a FREE financial calculator before going to Step #8
I am an advocate for financial calculators as I feel they are powerful instruments in certain Time-Value-of-Money (TVM) calculations useful to income and other investors. I recommend the TI BA II Plus Pro, which you can get as a free App from the Google Store. Here is a simple example of a TVM calculation you can easily do….
What is Wal-Mart's (NYSE:WMT) dividend CAGR through 2Q16 since 2007 just before the 'crash'? Since 2010 after the 'crash'? Well, the annual dividend/share paid up to the start of 2007 was $.672, up to the start of 2010 was $1.092 and over the past 4 quarters has been $1.98. So to calculate the 10.5 year and 6.5 year 'before-and-after' dividend compound annual growth rate (CAGR), we will key the following variables into the BA II you downloaded (note, the [ ] parentheses indicate the key that is being pressed. So [PMT] = 100 means type in 100 using the numeric keys and then press the PMT key. The display will show PMT = 100, meaning the number 100 is in the PMT register)
[2nd][CLR TVM] (the CLR TVM is the second function of the FV key, and it will clear any numbers in the calculators TVM registers, which are the horizontal row keys N - I/Y - PV - PMT - FV)
[N] = 10.5 (this means 10.5 compounding periods, which for this example is annual compounding periods)
[PV] = - .672 (If you input numbers in 2 of the PV, PMT or FV variable, one of them must be negative and one positive. By convention, a negative value means it is 'leaving you' and a positive (or no sign) number means it is coming to you or is available to come to you. To apply the negative sign, input the number (.672) and then press the +/- key on the bottom row)
[PMT] = 0 (there are no payments here… only beginning and ending values)
[FV] = 1.98 (the is the amount of the most recent 4 quarter dividend)
[CPT][I/Y] = 10.84% (the I/Y key = Interest rate per year).
Now, just go back up and overtype…
[N] = 6.5
[PV] = - 1.092
[CPT][I/Y] = 9.59%
So this tells us that WMT has had a dividend CAGR of 10.84% from the start of 2007 to present and 9.59% from the start of 2010 to present. Now, try this on your favorite dividend paying stock!
Now, you can certainly do this in Excel, but I've found the BA II much faster and easier. We will use this TVM function in the below calculations.
So Back to….
Step #8: Determine which distribution calculation will be used in determining the exact amount of the distribution. RR 2002-62 provides three approved methods for calculating the annual distribution requirement:
- The Required Minimum Distribution (RMD) method. This is calculated exactly the same way the RMD is calculated for one who is aged 70 ½, although the dates used to value to IRA may be different. So, assuming Emelia wishes to distribute the maximum amount allowed under this method, she would use the shortest life expectancy of 32.3 years (Table I) and divide this into the TIRA account value as of the designated valuation date per step #4 above. If the account value is $600,000, the first year's withdrawal would be 600,000/32.3 = $18,575.85 (3.1%). This is well below the $30,000 target Emelia has set. So If she included the entire $802,000 in the SEPP IRA, this would provide her with 802,000/32.3 = $24,829.72, which is still short of her household income need. But if she elects to use this method, the next annual calculation for the annual withdrawal amount for the second year will work just as the first year, except that she will re-enter the life expectancy Table I, and from this table at age 53, will have a new life expectancy of 31.4 years and the account will be valued at exactly the same point as had the previous year's valuation… for example, July 31 close-of- business. This will be repeated each year until, in Emelia's case, she attains age 59.5, as this will be well after the required minimum 5-year withdrawal period.
2. The Amortization Method. Simply put, this is the same calculation for a loan repayment. The $600,000 is the "loan" amount, 120% of the federal midterm rate is the 'interest rate on the loan" and the life expectancy… in this case 32.3 years from Table I… is the loan payback period. Using the financial calculator these are the keystrokes:
- [N] = 32.3
- [I/Y] = 1.716% (120% of July federal midterm rate of 1.43%)
- [PV]: 600,000
- [FV] = 0 (there is no residual value after all payments have been made
- [CPT] [PMT] = 24,351.95 (4.06%)
This represents the annual payments Emelia must take using the Amortization method.
3. The Annuitization method. This method is a bit more complicated to use. It requires that one determine an 'annuity factor' that represents the present value of an amount that would provide Emelia with $1/year over her remaining single life (Table I) expectancy. Here are the TI BA financial calculator key strokes:
- [N] = 32.3 years
- [I/Y] = 1.716% (120% of July federal midterm rate of 1.43%)
- [PMT] = 1 ($1 that would be paid each year over Emelia's life expectancy)
- [FV] = 0 (no residual value at end of life expectancy)
- [CPT][PV] = 24.639 = annuity factor
Now, divide 600,000/24.639 = $24.351.95 as the required annual distribution amount.
But when using an example given by the IRS of a 52-year-old, the annuity factor comes out to be slightly greater than 24.639. I believe this is tied to the single life table in Appendix B of RR 2002-62 being more current than the older single life table shown in Appendix B of Publication 590-B. The single life table in RR 2002-62 does not show the years of life expectancy, but instead shows the current survival rate for those in a given age group and the probability of survival over each successive year up to age 115. The IRS does not show how it derived the life expectancy used in the annuity factor, except to say it is an actuarial calculation. But in any event, if the table of survival data in the single life table of Appendix B of RR 2002-52 is always slightly longer than Table II life expectancy, then the annuitization method will always provide a smaller annual withdrawal than the amortization method. And even if the annuity factor used the PV of $1 over the Table II life expectancy, using the same interest rate, the required distribution would be the same for either method. Thus, I see no value in using the annuitization method over the amortization method.
4. Annual Recalculation. This is technically not a 4th option, but it can be viewed that way. This method, which has been derived from a past PLR, allows the IRA owner using the Annuitization or Amortization method to set it up to recalculate the annual withdrawal each year at the same time, using the same TIRA valuation date each year and using the same life expectancy table. What will vary year to year is the account valuation and, of course, life expectancy from the same table. The IRS has indicated that the annual revaluation is not a material modification to the SEPP plan. Because the RMD method already recalculates each year, this provision would not apply. The benefit of electing this method is the annual distribution amount can go up if the IRA value increases and the midterm interest rate increases. The risk of this is just the opposite: distributions will decline as the TIRA account value declines or the midterm interest rate declines.
Note that the method offering her the highest distribution rate (Amortization method) does not provide her with her $30,000/yr target using $600,000 as the initial account valuation. To achieve this, she will need to provide a greater 'base' to the SEPP TIRA. Working backwards using the TI Financial Calculator, the 'base' amount will be
[N] = 32.3 (years)
[I] = 1.716%
[PMT] = 30,000
FV = 0
[CPT] [PV] = $739,160.48
This would allow Emelia to keep about $62,840 in a separate IRA that is not part of the SEPP. She could use this as a sort of emergency fund if she required cash, although any withdrawal from this non-SEPP IRA will be subject to the 10% early withdrawal penalty.
Other significant planning issues
- Non-Qualified deferred annuities may also utilize the same SEPP provisions of an IRA and are covered under Sec. 72(q). The only difference is taxation: all withdrawals from deferred annuities come out earnings (untaxed) portion first, rather than prorated with basis as would happen with a TIRA (see later).
- The highest age the IRA owner attains in the year of the first SEPP distribution is the age used for the life expectancy tables
- For '5 Year SEPPs, which are those who begin the SEPP withdrawal after age 54.5, the final date of the SEPP will be 365 X 5 = 1,825 days after the first distribution is received. The TI BA II Plus calculator will calculate this future date and even the day of the week it occurs. However, the app version of the TI BA calculator, it seems, has a glitch and won't allow the number of days to be entered into the DATE function... although the actual calculator does this well. But as a general guide, adding 5 years plus a couple of days to account for any leap years along the way, will provide a future completion date. So if Emelia takes the first distribution on August 15, 2016 (a Monday), her 5-year anniversary will, according to my TI BA II Plus Pro DATE function, will be Saturday, August 14, 2021. As this is a weekend, the 5-year anniversary will be considered to be August 15, 2021.
- The RR 2002-62 added a provision that allows the IRA to switch from the Amortization or Annuitization method to the RMD method one time only. This decision would be irreversible and would require the switched plan to recalculate the RMD each year as it normally would. One cannot switch from the RMD method to the Amortization or Annuitization method. Although there is nothing in the code or Revenue Rulings to prevent this switch from occurring mid-year, most seem to agree that this switch should be done at the start of a new SEPP year.
- Another significant change with RR 2002-62 is the IRS ruling that if one depletes their SEPP TIRA before reaching the later of 59 ½ or holding the SEPP for at least 5 years, there will be no penalty… the SEPP will just stop.
- One may designate one or more TIRA or Roth IRAs (RIRA) as their SEPP IRAs. For valuation, all must be valued and combined as though one IRA. RIRA basis may always be withdrawn first from the RIRA without tax or penalty, so the only value of including a RIRA in the 'group' of SEPP IRAs is if it has large earnings relative to its value. Rollovers may be made between these SEPP IRAs in accordance with rollover rules.
- No amount may be materially added to the SEPP IRA(s) and no amount above that of the calculated SEPP withdrawal for the year may be distributed from the SEPP IRA(s) for the year. (A reduced prorated withdrawal is allowed in the first/last year of the SEPP. See below). Doing so would 'bust' the SEPP, subjecting all past taxable distributions to be subject to the 10% early withdrawal penalty plus interest. Violations of this the IRA owner feels are accidental or occurred beyond his/her control may be appealed to the IRS through a PLR, requesting an exception.
- Prorating of a partial year payment in the first or last year of the SEPP is allowed, per a past PLR, although the full annual amount may be taken for each of these periods. What Sec. 72(t) makes clear is that at least 5 years of annual withdrawals must be made. This provides two possible scenarios: The individual will reach 59 ½ before reaching a full 5 years,(called a '5 Year SEPP'), so this person may take a full withdrawal the first year and then the last year may take a full withdrawal, a prorated withdrawal or no withdrawal if he/she took a full withdrawal the first year. In any case, the IRA owner would have taken at least a 5 year withdrawal amount. The second scenario is like Emelia who will meet the 5-year withdrawal BEFORE reaching age 59 ½ (called a 59 ½ SEPP) which means she must withdraw up to the point she reaches age 59 ½ after having already met the minimum 5 year withdrawal. For her final year, this will allow her to withdraw the full annual withdrawal or a prorated withdrawal to get her up to the point of the year she attains age 59. However, just to be safe, most will take full withdrawal amounts each year, as they will likely need the household income anyway.
- Although Transfers-In-Kind are not prohibited, they should not be used… cash should be distributed and to the calculated penny. Some argue that rounding to the nearest dollar would be a deminimus event that would not be a substantial change to the annual withdrawal amount. But why give the IRS the opportunity to find fault. Stick with the calculated amount.
- Use account valuation date at the end of the month, as this is when the IRA custodian will usually report account valuation and so there is less room for conflict or error.
- Avoid withdrawal dates near the end of the month. This is particularly true in December, when IRA custodians tend to be busy and yours may be inadvertently delayed. Mid-month distributions are preferable.
- If the IRA owner will be setting up the SEPP, this should be done in writing. At a minimum, the written plan should include the IRA owner's name, Social Security Number and age (at the end of the first year of a distribution), the spouse's age (if a joint-survivor table (Table II) is used), the date the first distribution is received, the method to be used to make the distribution calculation, whether the amortization or annuitization method will be fixed over the life of the SEPP or will be recalculated each year, the IRA account(s) being used (show the account numbers) and the projected end date. Show the calculations for each year's withdrawals before they are made.
- Except for death or disability (as defined by the IRS), none of the other exceptions to the 10% early withdrawal penalty will apply to the SEPP IRA(s).
Tax Issues
If one's TIRAs, including rollover TIRAs, SIMPLE IRAs and SEP IRAs, have no basis (past after tax contributions), then all distributions received from the SEPP TIRA(s), will be treated as ordinary income. If the TIRA(s) owned by the IRA owner, collectively, have any after tax contributions, then each year that a withdrawal is made from the TIRA(s) the % of the TIRA balances made up of basis will be prorated with the percent of the withdrawal that will be a return of past after tax contributions. That the withdrawal happens to be coming from a SEPP designated TIRA(s) does not change this. This prorated percent is calculated using the form 8606, section I, and is calculated as of 12/31 at the end of the year. So if the total of Emelia's TIRAs is $790,000 on 12/31/2016, she must add back to this the total of the SEPP distribution of $30,000 for a 2016 valuation of $790,000 + $30,000 = $820,000. This amount is then divided into the existing after-tax basis of $76,000 (described earlier), for a basis percent of 9.3%. So the taxable portion of the 2016 SEPP withdrawal will be $30,000 X (1-.093) = $27,219.51 with the remaining $2,780.49 being non-taxable return of after tax contributions. The form 8606 filed in 2016 will replace the old one, and it will show the new basis of $76,000-$2,780.49 = $73,219.51. This process will then be repeated the next year.
As mentioned, RIRAs and TIRAs may be used in combination for a SEPP. What is not made clear is from which IRA the SEPP withdrawals are made first. The presumption here, short of getting a PLR, is that withdrawals would come first from the TIRA until depleted, and then withdrawals would come from the RIRA. But this seems a moot point, as there would be no incentive to include a RIRA with the SEPP, as why restrict tax free withdrawal of RIRA basis by including it with the SEPP… unless the RIRA is composed primarily of earnings that will be needed for income before age 59 ½….although I think it should be clear that this would be an unlikely situation. Possible, but unlikely.
A potential problem with SEPP administration is that, per my understanding in speaking with others, most IRA custodians have opted out of doing the calculations and administration of SEPP IRAs… most likely due to the growing complexity and lack of firm IRS rules on many of the administrative issues. Thus, for most, the form 1099-R issued by the IRA custodian for the previous year will be coded in Box 7 as Code 1, "Early distribution, no known exception," rather than Box 7 Code 2, which would indicate one of the early withdrawal exceptions such as the SEPP exception applies. The reason the IRA custodian codes it this way is because they don't know what we are doing, even though we may carefully explain it to them. This then will necessitate that we will have to file a form 5329 that year with the tax return, in which on line 1 and 2 of Part I are entered the SEPP distribution amount, with a code 2 in the space provided for the exception number. This will be repeated for each year the SEPP is in force.
A point of clarification. I was once asked why one in such a situation as Emelia wouldn't simply purchase a 10-year period certain annuity from an insurance company. The simple answer is the 10-year period certain annuity annual payment is based on a 10-year drawdown, not a lifetime drawdown, hence it would not be excepted from the 10% early withdrawal penalty.
Is the 72(t) significant for Income Investors?
For income investors who are living on the dividends of the companies they hold in their IRAs, as long as the current yield of these dividend paying stocks equal or exceed the percent of their SEPP IRA savings that must be distributed, the SEPP will have no effect on the income portfolio. So for Emelia, her SEPP distribution is 4.08% of her SEPP IRA value. As long as the current yield of her income portfolio exceeds 4.08%, the SEPP will not affect her ability to simply distribute the dividends paid. However, if the portfolio income is less than 4.08% yield based on today's valuations, Emelia may have to sell some of her dividend holdings, distribute the cash and repurchase the dividend paying stocks in a taxable account. An alternative to this is to transfer to the IRA used for the SEPP when it is being set up, the highest yielding stocks including preferred stock holdings. Collectively, these would have a better chance of meeting the cash income needed to meet the annual SEPP payout requirement without having to sell and repurchase the dividend paying stocks to meet the SEPP distribution requirement for the year.
Conclusion
For those retiring early and needing the income from their IRA savings, the only option available to avoid the 10% early withdrawal penalty would be to annuitize all or part of their retirement savings, using one of the IRS approved methods of calculating lifetime withdrawals that then must be taken each year for the longer of 5 years or until one attains age 59 ½. Today few IRA custodians are willing to take the responsibility of setting up and administering such an account, leaving it up to the early retiree or someone they hire to do it for them. So for those wishing to set up and administer their own SEPP plan, careful reading and planning will be the order of the day.
Acknowledgements
Some of my understanding of Sec. 72(t) rules are based on my experience, but because I have been retired from the industry for eight years I've had to rely on other sources for informational assistance:
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.