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What is a SEPP withdrawal?
A Substantially Equal Periodic Payment (SEPP) withdrawal is a method of accessing funds from an individual retirement account (IRA) or other qualified retirement plans (unless you still work for your employer) before reaching the age of 59½ without incurring IRS penalties for the withdrawals. This strategy allows you to tap into your retirement savings early without facing the typical 10% penalty for early withdrawals.
How does a SEPP withdrawal work?
To qualify for a SEPP withdrawal, you must follow specific guidelines set by the IRS:
- Substantially equal payments: The payments you receive must be equal in amount and frequency throughout the distribution period. This means you cannot vary the payment amounts or skip any payments.
- Based on life expectancy: The payment schedule must be based on your life expectancy or the life expectancy of your designated beneficiary. You can use IRS-provided life expectancy tables to determine the appropriate payment amount.
- Minimum five-year duration: You must continue receiving SEPP payments for at least five years or until you reach age 59½, whichever is longer. This ensures that the distributions are spread out over a significant period.
- No other withdrawals allowed: You cannot take any other withdrawals from the same retirement account while receiving SEPP payments. This prevents you from depleting the account too quickly.
- Only one active SEPP plan per year: You can only have one active SEPP plan for a specific retirement account in any given year. This ensures that the distributions are managed effectively.
Calculating SEPP payments:
The IRS provides three methods for calculating SEPP payments:
- Required minimum distribution (RMD) method: This method bases the annual payment on the account balance from the prior year. The year-end account balance is divided by the life expectancy factor from IRS guidelines to determine the annual payment.
- Fixed amortization method: This method uses an approved interest rate and life expectancy to calculate yearly payments, resulting in an even drawdown of the account balance. With this method, you don’t have to recalculate distributions each year and can simply take out the same amount each year.
- Fixed annuitization method: This method divides the retirement account balance by a number called the annuity factor, which is calculated using life expectancy and the federal mid-term interest rate. Once you know the account balance and the annuity factor for the first year, you can use the same amount as the annual payment for each following year.
Advantages of SEPP withdrawals:
- Financial support: SEPP plans allow individuals to receive a regular income from their retirement without penalties until they reach 59 ½. This can provide financial support during the transition period between the end of a career and the start of other retirement income sources.
- Avoid the 10% penalty: While the IRS generally imposes a 10% penalty on early withdrawals from retirement accounts, SEPP plans are an exception (among some others).
Disadvantages of SEPP withdrawals:
- Substantial penalties for canceling the plan: Once you begin a plan, you must continue for at least five years or until you reach age 59½, whichever is longer, or you’ll pay a sizable penalty. If the payments are modified or stopped before the five years are up, your taxes will increase by the amount avoided when starting the SEPP plus interest for the deferral period.
- Unable to change withdrawal amount: Even if your financial circumstances or life expectancy changes, you’re still stuck with the same payment amount, thus the “equal payments” part of SEPP.
- Reduces retirement savings: Once you start a SEPP plan, your account balance will decline, reducing your ability to grow your assets. Additionally, once you start withdrawals, you can’t contribute to the retirement account.
FAQs about SEPP withdrawals:
Who can use a SEPP withdrawal?
SEPP plans come with serious disadvantages and therefore should not be treated as a risk-free way to access money. However, if you’re near retirement age and lose your job and have few prospects for replacing the job, you might consider a SEPP plan. Or, if you need a steady stream of income and have no other resources, a SEPP plan might be your best bet. Keep in mind that although you won’t be hit with the 10 percent early withdrawal penalty, you’ll still be responsible for income tax on the withdrawals.
What is the penalty for canceling a SEPP plan?
If you cancel the plan before the minimum holding period of five years or before reaching 59½ years old, you must pay all the penalties saved by starting the plan, along with interest.
How do you set up a SEPP withdrawal?
Because SEPP plans come with some clear disadvantages, including tax penalties for incorrect calculations or early termination, your best bet is to consult a certified financial planner (CFP). A CFP and a tax expert can help talk you through your options.
SEPP withdrawals offer a way to access retirement funds before reaching age 59½ without incurring the 10% early withdrawal penalty. However, it’s crucial to understand the rules and limitations of SEPP plans before deciding whether this strategy is right for you. It’s highly advisable to consult with a financial advisor to determine if SEPP withdrawals are a suitable option for your specific financial situation and goals.
Required minimum distribution (RMD) method
The annual payment of a SEPP through the RMD method is determined by the account balance from the previous year. To calculate the annual payment, the IRS uses the Uniform Lifetime Table (Publication 590-B) and divides the year-end account balance by the life expectancy factor.
The fixed amortization method is intended to produce an even drawdown of the account balance by computing annual payments using an approved interest rate and life expectancy. By using this method, you can simply withdraw the same amount from your plan each year rather than having to recalculate distributions.
The retirement account balance is divided by a figure known as the annuity factor in the formula for this method. The federal mid-term interest rate and life expectancy are two specific pieces of information that are used to calculate the annuity factor. You can use the same amount as the annual payment for each subsequent year once you know the account balance and the annuity factor for the first year.
How substantially equal periodic payments work
You might be able to access your tax-advantaged retirement account before the age of 59 and a half without paying a penalty of ten percent by establishing a substantially equal periodic payment plan. This is not a free lunch; you will still pay income taxes on the payments; what’s different is that you won’t have to pay the extra 10 percent penalty that usually comes with withdrawals for people under 59 ½.
You’ll need to abide by a few key rules when using the SEPP strategy, according to IRS Section 72(t):
- Payments from SEPP must be substantially equal; otherwise, you risk losing your ability to make withdrawals without incurring penalties. Payments have to be determined by the life expectancy of the beneficiary or the taxpayer.
- You are not allowed to work for the organization that funds the retirement account. For instance, you have to withdraw money from a previous employer’s 401(k) if you would like to.
- Withdrawals from the account are required for a minimum of five years, or until the age of sixty-nine, whichever comes first. Thus, you must utilize the plan for a minimum of five years.
- The account from which you are withdrawing the SEPP cannot be used for any other withdrawals.
- In any given year, you are not permitted to have more than one SEPP plan active for the account.
You will be responsible for paying large fees if you terminate the SEPP plan before its expiration date. All penalties that you could have avoided will have to be paid, along with interest on that sum.
On the other hand, you will not be penalized for that year or for not finishing the SEPP plan if you empty the account before paying for the entire year.
There are three allowable methods for calculating payments, covered below.
The IRS provides three methods for determining SEPP payments: the required minimum distribution (RMD) method, the fixed amortization method and the fixed annuitization method. Each method has its own rules and guidelines for calculating payments. However, the IRS states that other methods may be acceptable to fulfill the condition of substantially equal payments.
During the SEPP plan, you are only permitted to switch the payment method once, and that too only if you switch from the fixed annuitization or fixed amortization model to the RMD model. Here’s an overview: