Your 56-year-old client lost her job last year and needs additional income until she’s back at work. Her IRA accounts have large balances but she doesn’t want to incur the 10 percent penalty for pre-age 59 ½ distributions and she can’t qualify for the usual penalty exemptions.

The substantially equal periodic payment (SEPP) exception could be a viable solution The SEPP calculator at BankRate.com can help you calculate qualifying payouts; the IRS also provides guidance. Nonetheless, it’s a potentially complex decision. Your client can choose from three distribution methods and any violation of the compliance regulations will trigger penalties.

LifeHealthPro asked April Caudill, JD, CLU, ChFC, AEP, senior attorney advanced planning with Northwestern Mutual in Milwaukee, Wisconsin, for her insights on helping clients make the right decisions with SEPPs. Here are her emailed responses.

LifeHealthPro: How do SEPPs work?

April Caudill: SEPP stands for series of substantially equal periodic payments.

SEPPs are an exception to the 10 percent penalty on early distributions from IRAs and other qualified accounts. Basically a SEPP provides access to retirement funds penalty-free prior to age 59 ½, if certain very stringent requirements are met. After the client reaches age 59 ½, the penalty no longer applies, but an already-started SEPP might be required to continue if the payout has not met the minimum 5-year requirement. 

With one exception, which I discuss below, the SEPP cannot be modified until the later of two events occurs: the client either reaches age 59 ½, or completes five years of payouts. If the payout is modified before this point, the 10 percent penalty is triggered on the entire payout, all the way back to the year it began. 

The SEPP must be calculated according to one of three formulas. Briefly, the three methods are known as the (a) required minimum distribution (RMD) method, (b) amortization method, and (c) annuitization method. There are very specific rules for these calculations, but the important things to know are that:

    • The amortization and annuitization methods will generate a level payout, and it will be higher than a payout under the RMD method;
    • The RMD method generates a payout that changes each year, depending on the account value, but it “ties up” more of the client’s IRA funds for a given payout level; and
    • A once-in-a-lifetime change to the RMD method is permitted. (Picture the economy tanking sometime after the SEPP is commenced, and the IRA owner needs to lower his/her payment to the lowest permitted level, to preserve more of the IRA value for the long-term future.)

LHP: When do SEPPs make sense? Not make sense?

April Caudill: They might make sense for IRA owners who find themselves out of work in their 50s, or who need access to a payment stream from their IRA before age 59½ for some other reason. They do not make sense for individuals who are much younger. The younger the client, the longer the payout is required to continue and the greater the potential for a mistake that triggers the 10 percent penalty back to day one.

LHP:What factors should a client consider in the selection of a particular SEPP payout method?

April Caudill: It is very important to remember that under all methods, the calculation must be made as if the payout were for life, even though it is not required to continue for life. In other words, a 5-year or 10-year term certain payout for someone in their 50s will not satisfy the requirements. 

Many experts recommend that an IRA owner use only part of their total IRA funds to generate a SEPP, and to keep that IRA entirely separate from their other IRA funds. That way, if the individual has an additional financial need and must take more IRA funds, he or she does not end up having to “break” (that is, modify) their SEPP.

It is very easy to make mistakes that trigger a modification of a SEPP, and therefore, a retroactive penalty. Clients should make sure they have expert assistance from start to finish.