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Retirement Planning
Substantially Equal Periodic Payments
IRS Provides Welcome Relief to Taxpayers Using Substantially Equal Periodic Payments.
Generally, qualified retirement plan and IRA distributions made prior to age 59½ are subject to a 10% premature distribution penalty. There are, however, several exceptions to the premature distribution penalty including death, disability, higher education expenses, first time home purchases ($10,000 lifetime limit) and substantially equal periodic payments (SEPP).
Under the SEPP exception, a retirement plan participant or IRA owner takes annual distributions until age 59½, or for five years, whichever is longer. Once elected, the taxpayer is generally locked-in to their distribution schedule, and any deviation will immediately trigger the 10% penalty, plus interest, on all prior year distributions. The amount of the annual distribution is calculated using one of three safe-harbor options, which must be selected at the time distributions begin:
- Life Expectancy Method. Under the life expectancy method, each annual distribution is based upon the individual's prior December 31st account balance and attained life expectancy. Annual payments, therefore, will vary.
- Amortization. Under the amortization method, the annual distribution is determined by amortizing the account balance over the individual's life expectancy using an assumed interest rate. Under this method, the annual payment is calculated in the first year SEPP begins, and remains the same throughout the entire period.
- Annuitization. Similar to amortization, the annual payment remains the same throughout the SEPP period. The annual distribution is determined by dividing the initial account balance by an annuity factor that is the present value of an annuity of $1 per year, using an assumed interest rate, continuing for the life of the individual.
Unfortunately, many individuals have witnessed their retirement account balances decrease significantly over the last few years. As a result, individuals using the amortization or annuitization methods could potentially deplete their retirement account balance well before their SEPP period concludes, hardly the intent of the SEPP exception.
The Internal Revenue Service provides relief for those individuals who wish to decrease their annual distribution, without incurring the 10% penalty on prior year distributions. Under Revenue Ruling 2002-62, individuals using amortization or annuitization are allowed to make a one-time election to switch to the life expectancy method. Once the election to switch methods is made, the life expectancy method must be used to calculate all future year distributions. The resulting lower annual distributions will allow many individuals to preserve more of their balance for retirement. The one-time election is available now, or may be used in the future.
For those individuals who began SEPP after January 1, 2003, Revenue Ruling 2002-62 provides further guidance including:
- Under any of the safe-harbor methods, an individual may calculate their life expectancy using the Uniform Life expectancy, single life expectancy or joint and survivor life expectancy tables.
- If the joint and survivor table is used, the survivor must be the beneficiary in the year SEPP begins. If there are multiple beneficiaries, the survivor's life expectancy is based upon that of the oldest beneficiary.
- The maximum interest rate assumption that may be used is 120% of the federal mid-term rate.
- When calculating the first year distribution, it appears the account balance that is used may be either the current or prior year-end balance.
- The SEPP schedule is considered modified, and the 10% penalty imposed, if 1) assets are contributed, transferred or rolled over to the SEPP account; 2) assets are transferred from the SEPP account to another retirement account; or 3) a SEPP is rolled over to another retirement account.
The ability to withdraw money from your retirement account without penalty can play a vital role in your overall financial plan. The rules governing SEPP are complicated, and could potentially trap many unwary novices. Be sure to work closely with your Financial Advisor, as well as your CPA or tax advisor.
Smith Barney does not provide tax or legal advice. Please consult your tax and/or legal advisor for such guidance.
For more information, please contact your Financial Advisor.