Clients Can Tap 401(k)s and IRAs Early Without Penalty, but Beware

Retirement savers with a 401(k) or IRA can take penalty-free withdrawals from the account before age 59 ½, regardless of their situation, through a Series of Substantially Equal Periodic Payments, or SOSEPP.

SOSEPPs are part of section 72(t) of the IRS code governing exceptions to rules for retirement account early distributions. While they can be a source of cash for clients, SOSEPPs are subject to strict IRS rules with steep consequences if violated. Advisors with clients taking these withdrawals must give careful guidance.

How Does a SOSEPP Work?

A SOSEPP can be taken from an IRA or 401(k). For clients under 59 ½, this is a way to tap their account without incurring the 10% early withdrawal penalty. 

Once a SOSEPP is started, your client must continue to take these distributions for at least five years, or until they reach age 59 ½, whichever is longer. Stopping the payments early will result in penalties and interest in most cases. 

If your client has multiple IRAs or 401(k)s, they can choose to do a SOSEPP on one account without affecting the others. 

 There are three distribution methods the IRS allows for a SOSEPP: 

• The RMD method uses the appropriate life expectancy table for your client’s situation to calculate the SOSEPP payments each year. The amounts are calculated at the end of each year, much like RMDs. 
• The amortization method allows clients to set a fixed amortization rate over a set number of years, based on the appropriate life expectancy table and the interest rate rules in place at the time.
• The annuitization method is based on an annuity factor from the IRS and the interest rate rules in place at the time. 

Prior to 2022, the interest rate could not exceed 120% of the federal midterm rate published by the IRS. New rules discussed below offer a new option for a higher interest rate for SOSEPPs starting in 2022 or later. 

The payments under both the amortization and annuitization methods remain the same over the period of the SOSEPP. Clients have a one-time opportunity to switch to the RMD method if they so desire in the case of an IRA. 

The RMD method generally results in the lowest initial payment of the three methods, but if there is significant growth in the account balance, the RMD method could result in higher payouts over time.

Why Use a SOSEPP?

There are some exceptions in the rules that allow penalty-free withdrawals from IRAs and 401(k)s for reasons such as unreimbursed medical expenses, death, disability and other similar reasons. Beyond these types of situations, a SOSEPP may be the best way to tap an IRA or 401(k) early without incurring the 10% penalty. 

One situation where a SOSEPP might be applicable is with a wealthy client who wants to retire early and who has a large amount of their assets concentrated in an IRA. Let’s say the client has $10 million in an IRA. Under the rules, they could divide their IRA into two or more separate IRA accounts. 

You might advise the client to do a SOSEPP on one account starting at age 50, leaving the remaining IRA balance intact until age 59 ½ or later. If needed, the client could tap into all or part of the remaining IRA balance later, either via another SOSEPP or by taking a one-time distribution and simply paying the penalty.

In another potential scenario, your client might find themselves in a situation where they need cash and their retirement account is their only source of sufficient funds to meet their need. A SOSEPP would be their best option in this type of situation.   

SOSEPP Tax Traps

SOSEPPs can be a veritable minefield of tax hazards. First of all, any deviation from the specified payment under the method used will trigger a 10% penalty not only on that year’s payment, but on all of the payments taken in prior years. Additionally, this will trigger interest on any unpaid taxes or penalties up to the date that your client broke the SOSEPP. 

The exception to this is the one-time opportunity to switch from the annuitization or amortization method to the RMD method. 

Another potential issue is dealing with a custodian who lacks experience with SOSEPPs. An inexperienced or unknowledgeable custodian who doesn’t understand the process can inadvertently trigger a violation of the SOSEPP along with the tax issues discussed above. While a situation like this might result in the IRS forgiving some or all of the penalties, this isn’t something you or your client should count on. 

Tapping retirement accounts prior to age 59 ½ can limit your client’s income in retirement from these accounts. It is important to discuss this issue in detail with clients prior to embarking on a SOSEPP. 

The Impact of New SOSEPP Rules for 2022

Beginning in 2022, new IRS guidance offers the ability to use an interest rate as high as 5%, or 120% of the federal midterm rate, whichever is higher. This IRS guidance also introduces longer life expectancy tables for 2022. Overall, these changes make SOSEPPs more attractive in terms account holders’ ability to receive larger payments. 

While the longer life expectancy tables would serve to reduce the payments, the use of the higher interest rates would serve to increase payments significantly compared with most SOSEPPs started prior to 2022. 

There is still some ambiguity regarding the new rules in terms of issues such as whether the new interest rate rules can be combined with the old life expectancy tables as the IRS update regarding these tables for RMDs did not specifically address SOSEPPs. These and other issues that may be unclear regarding SOSEPPS will hopefully be answered by the IRS via an update at some point. 

Additionally, IRS notice 2206 indicates that a SOSEPP using the RMD method can switch to the new life expectancy tables. There is some confusion as to when this switch can or must occur. The notice did make clear that a SOSEPP that was commenced under the annuitization or amortization methods prior to the issuance of this notice cannot switch to the new higher interest rate. 

Conclusion

Tapping into retirement accounts early is generally not a good idea for clients. But in situations where this either does make sense or is necessary for your client, they will need your guidance and expertise to ensure the SOSEPP is executed correctly and that they reap its maximum benefits.

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