What You Need to Know
- To take advantage of the SEPP exception, the IRA owner can set up a series of equal periodic payments.
- The exception applies as long as the SEPP remains in place for five years or until the client turns 59½, whichever is longer.
- The SEPP strategy is for IRA owners only. Clients with only a 401(k) must establish an IRA and roll the 401(k) funds over.
Countless clients left the workplace in the wake of the COVID-19 pandemic. Some left to start a business and gain independence. Others may have simply been fed up and ready to retire early. Unfortunately, those clients who elect to retire young may be subject to significant penalties if they also need to start withdrawing funds from traditional retirement accounts before reaching age 59½.
This “early retirement tax” can quickly put a damper on early retirement. If withdrawals are structured properly, however, the client may be able to take advantage of an often-overlooked exception to the early withdrawal penalty: the substantially equal periodic payment (SEPP) exception.
Early Withdrawal Penalties: The Basics
Most clients know the basic rules. Taxpayers are entitled to contribute a limited amount of pretax dollars to their 401(k)s and IRAs each year, thereby reducing tax liability.
To encourage those people to save the funds until retirement, a 10% early withdrawal penalty applies if the client starts withdrawing funds before reaching age 59½.
The IRS also recognizes, however, that there are situations where a client might legitimately need to access retirement funds early, so there are exceptions to the rule.
Clients can access retirement funds early and without penalty in the event of (1) death, (2) disability, (3) reaching age 59½, (4) to cover certain unreimbursed medical expenses, (5) purchasing a first home (this exception is limited to IRA withdrawals of $10,000 or less) and (6) a series of substantially equal periodic payments (SEPP).
How Does the SEPP Approach Work?
Assuming the client retires voluntarily (or was involuntarily terminated and elects not to return to work) rather than because of a disability, the SEPP approach may be the only available exception.
To take advantage of the exception, the IRA owner can set up a series of equal periodic payments. The payments can be made monthly, quarterly or even annually to avoid the 10% penalty.
But the exception applies only as long as the SEPP remains in place for the longer of (1) five years or (2) the date the client reaches age 59½.
So, if the client begins the SEPP at age 58, they’ll have to continue the stream of payments until age 63, even though the early withdrawal penalty wouldn’t have applied for the last 3½ years “but for” the SEPP. If the SEPP is ended or modified early, the 10% penalty applies for the entire SEPP term (plus interest).
The SEPP payment is calculated based on one of three different options: the fixed annuity option, the fixed amortization option or the required minimum distribution option. Each of these options is designed to replicate a drawdown of the account over the owner’s life expectancy.