SOSEPP Plan Allows Withdrawal Prior to 59½ and Avoids Early Withdrawal Penalty
Inevitably, situations arise where a client may require access to retirement funds prior to reaching age 59½, when penalty-free withdrawals are possible. Limited exceptions to the 10% early withdrawal penalty exist, including the IRC Section 72(t) exception for clients who set up a series of substantially equal periodic payments (SOSEPP) from the retirement account. Still, even with a SOSEPP, clients take an income tax hit.Traditional retirement account distributions are always taxable — even if an exception to the 10% early withdrawal penalty applies. Only Roth retirement dollars can be taken tax-free. But what if a client with no existing Roth funds could combine a Roth conversion strategy with the SOSEPP strategy? While it may seem counterintuitive, complex scenarios call for complex planning strategies and solutions — and situations can occur where a client may be willing to take a one-time tax hit in exchange for years of tax and penalty-free access to retirement dollars prior to age 59½.
SOSEPPs: The Basics
An IRA owner can set up a series of substantially equal periodic payments (the payments may be made monthly, quarterly or even annually) and avoid the 10% early withdrawal 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 IRS-approved options: (1) the fixed annuity option, (2) the fixed amortization option or (3) the RMD option. Each is intended to mimic a draw-down of the retirement account over the owner's life expectancy.
The payment amount is based on the client's life expectancy and an interest rate.Notably, the IRS released guidance in Notice 2022-06 that allows payment schedules beginning in 2022 and after to use an interest rate that is as high as 5% (or the client can elect to use pre-2022 rules, meaning calculating the SOSEPP based on 120% of the federal mid-term rate in effect for either of the prior two months). In general, this change the SOSEPP option more attractive for a wider range of clients.
SOSEPPs and Roth IRAs
If the client already owns a Roth IRA and needs tax and penalty-free access to their retirement dollars, it will make the most sense to first access the Roth IRA. Direct Roth IRA contributions are always available tax-free—because Roths are funded with after-tax dollars, the owner has already paid taxes on those contributions.
If a client doesn't already have a well-funded Roth IRA, it might make sense to execute a conversion and immediately establish a SOSEPP to secure tax and penalty-free access to the Roth funds. That's because not all Roth dollars can be withdrawn tax and penalty-free.Holding periods apply.
Here's where understanding the distribution rules becomes particularly important. Roth funds are always divided into three buckets: direct contributions, converted dollars and earnings. Roth IRAs follow an ordering rule.When the owner takes a distribution, it's treated first as though it comes from the direct contribution bucket. Once that direct contribution bucket is "empty," the remaining distribution is then treated as though it comes from converted dollars.Only once all contributions and converted dollars are withdrawn will the earnings bucket be touched.
Earnings on contributions may be taxable if the account owner hasn't owned the Roth for at least five years. It's also possible that an early withdrawal penalty could apply. When a client executes a Roth conversion, the converted amounts can be accessed tax-free — but a 10% early withdrawal penalty will apply if the converted amounts are withdrawn within five years of the conversion and the owner isn't at least 50 ½ years old. A separate five-year clock applies to each conversion.
If a client does not already own a Roth IRA and needs tax and penalty-free access to retirement dollars prior to age 59½, it can make sense to execute a large Roth conversion. Because the client had no direct Roth contributions, distributions would first come from the converted amounts (so without the SOSEPP, they would be subject to the 10% penalty). Once the amounts are converted, the client can establish a SOSEPP under IRC Section 71(t) to avoid the 10% penalty. After five years have passed, the client can stop the SOSEPP payments and will have satisfied the relevant holding period requirement.
Conclusion
Establishing a SOSEPP with Roth funds is generally only useful for clients in very specific situations — clients with no existing Roth funds who are under age 59½ and would rather take an income tax hit in one year in exchange for future tax and penalty-free access. The rules governing each strategy are complex on their own—so securing trusted advice is always critical to avoiding costly mistakes.