SEPPs From An IRA: Don't Change Horses Midstream
Suppose you have a major financial obligation looming on the horizon—higher education expenses, a wedding for one of your children, or a medical procedure that isn’t covered by insurance. If coming up with the cash is a concern, you may need to think outside the box. One option is to tap your traditional IRAs.
Before we go any further, remember that an IRA is designed to help provide income during your retirement years. A decision to raid your retirement plans early shouldn’t be made lightly. If you do choose this course, however, you can sidestep a costly tax penalty by taking “substantially equal periodic payments” (SEPPs) from your accounts, as long as you meet the requirements spelled out in the tax law.
Any distribution from a traditional IRA is taxable at ordinary income tax rates to the extent that it represents deductible contributions and earnings. To make matters worse, you could be slapped with a 10% tax penalty on the taxable portion of a payout received before age 59½, on top of the regular income tax you’ll already owe. But there are a few key exceptions to the penalty included under section 72(t) of the Internal Revenue Code.
For cash-hungry IRA owners, one relatively painless way to avoid the penalty is to have your IRA custodian pay out SEPPs. To qualify for this exception, the payments must be made from the account for a period of at least five years or until you reach age 59½—whichever is longer. For example, if you’re now age 55, the payments only have to last for a period of five years. If you’re younger—say, age 45—you must continue payments for another 14½ years,
How much should you withdraw? The IRS has approved three specific methods for calculating the payment amounts. Generally, you can’t switch from one method to another during the time you’re receiving payments. If you do, you will trigger the penalty dating back to the time you began withdrawals. The three permissible methods are:
1. Required minimum distribution (RMD) method. Your annual withdrawal is determined by dividing the account balance by the number from the applicable IRS life expectancy table for the year. Let’s say you have an IRA balance of $1 million and your life expectancy, according to the table, is 30 years. Your payment the first year will be $33,333.33. With this method, your payments will vary slightly from year to year, thanks to your changing life expectancy and fluctuations in the value of the account.
2. Fixed amortization method: Your annual withdrawal is determined by amortizing the account balance over a period of years using a life expectancy table and an assumed interest rate. The IRS allows you to choose from two different life expectancy tables and several interest rate assumptions. But once you’ve made those selections, your annual payments won’t vary from year to year.
3. Fixed annuitization method: Your annual withdrawal is determined by dividing the account balance by an annuity factor derived from a mortality table with an assumed interest rate. In this case, the amount of the annual distribution also remains the same over the length of the distribution period.
Which method is preferable? The RMD method is generally the easiest to use and provides the smallest payout of the three methods. With this option, you’re more likely to preserve a bigger IRA nest egg for retirement. But you might choose either one of the other two methods if you need additional cash in a hurry.
A switch in time: As mentioned above, you normally can’t change horses in midstream. But recent IRS guidance issued in Rev. Rul. 2002-62 permits you to change one time—and one time only—from the fixed amortization method or the fixed annuitization method to the RMD method. Such a change might make sense if the value of your account is being drained faster than you expected and you’d like to scale back on the payments. A switch to the RMD method may also be advisable if you’ve recently suffered investment losses in your account.
Can you take payments from more than one IRA? You can set it up however you like, but you must calculate your payments separately for each IRA. Once you start taking payments from a particular IRA, you have to continue to take SEPPs from that IRA for the longer of five years or until you reach age 59½.
The exception for SEPPs can be a life-saver if you’re unexpectedly caught short of funds. Please call our office if you would like to explore your best approach.
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