Rocky Market Choices: Evaluating SOSEPP Changes for Declining IRA Balances

by Prof. Robert Bloink and Prof. William H. Byrnes

Typically, a 10% early withdrawal penalty applies in situations where a retirement plan owner accesses their retirement funds prior to reaching age 59 ½.   One exception to the early withdrawal penalty applies when the funds are accessed via a series of substantially equal periodic payments, or “SOSEPP” under IRC Section 72(t).  Three permitted methods for calculating the value of the SOSEPP exist—and, generally, once an individual selects their distribution method, they are required to stick with that choice.  In a down market where the value of an IRA has declined, individuals who have selected a SOSEPP method may question that choice—simply because the payment amount may now amount to a much larger portion of the overall IRA balance.  Today, clients should understand their options for modifying their SOSEPP—being vigilant to follow the rules regarding permissive changes to avoid a potentially significant early withdrawal penalty.

Calculating the Value of a SOSEPP

SOSEPPs are exempt from the 10% early distribution penalty that applies to traditional retirement account distributions prior to age 59 1/2.  The IRA owner can set up a series of equal periodic payments (whether the payments are made monthly, quarterly or even annually) and avoid the 10% penalty as long as the SOSEPP remains in place for the longer of (1) five years or (2) the date the recipient reaches age 59 1/2.  If the SOSEPP is ended or modified prior to that time, the 10% penalty applies (plus interest).

The SOSEPP payment is calculated based on one of three different options (the fixed annuity option, the fixed amortization option or the RMD option) that mimic a draw-down of the account over the owner’s life expectancy.  The most commonly used options are the annuity and amortization methods, because they tend to result in a larger SOSEPP payment.  The payment amount is based on the client’s life expectancy and an interest rate that's historically been based on the federal mid-term rate in effect for either of the two months prior to the start of the SOSEPP schedule (the rate could not exceed 120% of that federal mid-term rate).

Beyond those rules, clients can structure their payments using a single life expectancy or joint life expectancies of the IRA owner and designated beneficiaries.

Changes to SOSEPPs in Today’s Turbulent Market

In recent years, the required interest rate for calculating SOSEPP amounts has been extremely low.  In other words, the client’s payments were typically much lower than needed because of the low-interest rate assumptions that were in place, so that the SOSEPP payment method wasn’t useful for many clients.  Further, the IRS has updated life expectancy tables so that the client’s SOSEPP would have been calculated using a longer life expectancy—which further reduced the SOSEPP payments if the client’s SOSEPP was calculated using the annuity or amortization methods.

However, the IRS released guidance in Notice 2022-06 that allows payment schedules beginning in 2022 and thereafter to use an interest rate that is as high as 5% (or the client can elect to use the old rules, meaning using 120% of the federal mid-term rate in effect for either of the prior two months)—making the SOSEPP option more attractive for a wider range of clients.

The recent market downturn has resulted in declining IRA balances, so that the payments now become a much larger portion of those IRAs—meaning, obviously, that the client may deplete their balance much sooner than expected.  Those clients should understand that the IRS does permit a one-time change from the annuity or amortization methods to the RMD method of calculating the SOSEPP.  Because the RMD method typically results in a smaller payment, that option may be attractive for clients who are now worried about their declining IRA balances.

Clients making the change should understand that the change is permanent through to the end of the original SOSEPP period.  Any other modification would trigger the 10% early withdrawal penalty—which is applied retroactively, so can be significant.  Clients who have experienced a significant decline in their IRA value should also be advised that it may be a wise move to convert to a Roth while balances are low (thus reducing the tax liability on conversion).  After conversion, the client must still continue with their SOSEPP payment schedule to avoid penalties.

Conclusion

SOSEPPs today have become much more attractive given the modifications made to the rules back in 2022.  With today’s rocky market conditions, clients may wish to consider a change to account for reduced IRA values—ensuring that any change complies with the once-only modification rules and with the understanding that no further changes can be made through the end of the original SOSEPP period.