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What Are Substantially Equal Periodic Payments (SEPP) – Rule 72(t) Distributions

By Kira Botkin

golden egg cash handIf you’re lucky enough (and prepared enough) to retire early, you may run into a little snag when you try to withdraw money from your IRA or 401k: You’ll be charged a 10% penalty for taking it out before the age of 59 1/2.

However, one way many early retirees get around this is by withdrawing specific amounts of money in substantially equal period payments, or SEPP. It’s also known as the 72(t) rule, after the IRS code section to which it refers.

An SEPP plan allows you to withdraw money without getting the 10% penalty, as long as you adhere to specific rules set out by the IRS.

Substantially Equal Period Payments (SEPP)

SEPP Withdrawals

You can choose one of three different methods to determine how much to withdraw and stay within SEPP rules.

  • Required minimum distribution method. This is based on your life expectancy (or the joint life expectancy of you and your beneficiary) and your account balance. It’s recalculated by the IRS every year.
  • Fixed amortization method. This calculates payments based on your account balance and a specific rate of return. Even if your account outperforms the rate of return, you still withdraw the same amount.
  • Fixed annuity method. This uses an annuity factor from a mortality table with a reasonable rate of interest to calculate a fixed payment.

Choose the calculation method that best suits your needs – whether you want to get the most money out now, or preserve your account for later. The required minimum distribution method will generally allow you to withdraw less than the other two methods. And since it’s recalculated every year, you’ll be protected from over-withdrawing during market declines. Use this tool from Fidelty to calculate your withdrawals under the amortization or RMD methods.

Keep in mind that if you withdraw too much money, the IRS can treat it as an early withdrawal and assess the 10% penalty on the extra amount. It may help to have an accountant double-check your figures on a regular basis to make sure you won’t be penalized.

If you start an SEPP plan and want to change the calculation method, you can only do so once, and only if you’re going from one of the fixed methods to the RMD method. Otherwise, all of your previous payments will be declared invalid and hit with the 10% penalty – so be careful!

Length of SEPP Plans

An SEPP plan must be in place for at least five years or until you turn 59 1/2, whichever is longer. If you start an SEPP plan when you’re 58, you’ll have to continue it until you’re 63, even though you’ll have already reached retirement age.

Consider if you really need the money for all five years, especially if you’re near retirement age and will be getting a pension or Social Security check soon. Remember, even if you don’t need them, you’ll be forced to continue taking payments for five years, or face heavy penalties.

However, if you’re happy with your SEPP distributions, you can continue them indefinitely. Depending on the method chosen, minimum distributions from an SEPP will be equal to or greater than the required minimum distributions once you turn 70 1/2.

You can discontinue an SEPP plan early if you become disabled, die, or deplete the account.

Taxes on SEPP Withdrawals

SEPP withdrawals are taxed, and if you withdraw early from a Roth IRA under an SEPP plan, you’ll be taxed on those distributions as well. Ordinarily, Roth distributions aren’t taxed, as long as they’re taken after 59 1/2. The 10% penalty is waived with an SEPP, but not the requirement that you pay income tax on earnings withdrawn before retirement age.

However, contributions to a Roth IRA that are at least five years old can be withdrawn at any time for any reason without being taxed or assessed a penalty. This is one instance where “account diversification” (i.e. having more than one type of retirement account) can really help. If you have money in a traditional IRA or 401k, you can choose to tap that account instead of a Roth. You’ll still pay taxes, but no more than you’ll pay if you wait until you’re 59 1/2 to take withdrawals.

Another consideration is that since your SEPP withdrawals will increase your taxable income, they can affect the amount of Social Security income that is taxed. While this may not be an issue for early retirees, it may affect those whose five-year SEPP period extends past age 62, or who have a spouse that receives Social Security income. If your SEPP amounts are fairly large, talk to a CPA to see how they will impact your tax bill.

Other SEPP Guidelines

  • Payments must be made from the account at least once per year .They can be made up to once per month, but each payment should be equal.
  • Once you start an SEPP plan, you can’t transfer money in or take distributions from the account other than the SEPP distribution.
  • You can’t start an SEPP in a 401k that’s with a company you still work for.
  • You must choose how much to withhold from your SEPP distribution for federal taxes. You can even choose to withhold $0. If you don’t make a choice, your financial management company will automatically withhold 10%.
  • Since SEPP distributions are taxable income, make sure your financial management company is withholding enough or that you are making estimated tax payments on a quarterly basis. If you fail to do either, you could be assessed an underpayment penalty at the end of the year, not to mention owing a very large tax bill. Talk to a CPA, especially if you receive other taxable income, to determine the best course of action.

What If My SEPP Distribution Is More Money than I Need?

If you only need a certain amount of money during your five-year SEPP period, do some prep work to make sure you won’t have to withdraw too much. After all, you don’t want to give up tax-deferred growth if you don’t have to. Use a calculator to determine how much you need in your account to get the amount you want to withdraw.

Transfer the excess money to another IRA. Then, set up an SEPP with the original IRA which now contains the amount of money you need to get the withdrawal you want. Do these calculations before you set up your SEPP distributions. Remember, while the SEPP plan is in place, you can’t add money or withdraw more than your SEPP amount without getting penalized.

Final Word

If you planned ahead and are ready to tap your retirement accounts, consider the rules to avoid the penalties. When seeking professional assistance, such as with a CPA or financial advisor, quiz them on what a SEPP plan, or 72(t), is. There are plenty of professionals who are not familiar with this plan, though they may be expertly qualified in other areas. If done correctly, setting up a SEPP plan can be a great way to start an early retirement.

At what age are you planning to retire? If you’ve retired early, what is your experience with SEPP distributions?

(photo credit: Shutterstock)

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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