Substantially equal periodic payments

Introduction
One way an investor can tap a traditional IRA before the age of 59 1/2 without triggering the 10% early withdrawal penalty tax is to initiate a program of Substantially Equal Periodic Payments (SEPP). These penalty free payments are allowed under the Internal Revenue Code sections 72(t) and 72(q). The IRS allows payments to be calculated according to three approved methods. Once initiated, the payments must be maintained for the greater of either 5 years or until the attainment of year 59 1/2. The individual establishes whether the payments from the IRA are to be made monthly, quarterly, or annually. Failure to maintain payments, or their periodicity, results in the imposition of the 10% penalty tax for early withdrawals on all prior withdrawals. In addition, once an SEPP program has been established for an IRA, a lump sum withdrawal from the IRA before the tenure requirements have been met (age 59 and 1/2 or five years and a day) will trigger the penalty tax. Thus if you establish an SEPP at age 57, any lump sum withdrawals from the SEPP IRA before age 62 will trigger the penalty tax, even if it occurs after age 59 and 1/2. The solution to this problem is to establish a single or multiple SEPP IRA program on a portion of your IRAs, leaving some of your IRAs out of the program. On your tax return SEPP withdrawals are filed on IRS Form 5329 if the IRA custodian does not enter code "2" ("Early distribution, exception applies) on the 1099-R form you will receive each year.

Approved Withdrawal Methods
The IRS approves three withdrawal methods for SEPPs:


 * Required minimum distribution method - The required minimum distribution method consists of an account balance and a life expectancy (single life or uniform life or joint life and last survivor each using the age(s) attained in the year for which distributions are calculated). The annual payment is redetermined for each year. The RMD method produces a variable income distribution as the market value of the IRA portfolio fluctuates and as the life expectancy factor changes. In general, the single life table produces higher income withdrawals than does the joint life or uniform tables.
 * Fixed amortization method - The fixed amortization method consists of an account balance amortized over a specified number of years equal to life expectancy (single life or uniform life or joint life and last survivor) and a rate of interest that is not more than 120 percent of the federal mid-term rate published in revenue rulings by the Service. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years. In general, the single life table produces higher income withdrawals than does the joint life or uniform tables.
 * Fixed annuitization method - The fixed annuitization method consists of an account balance, an annuity factor, and an annual payment. The age annuity factor is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and a rate of interest that is not more than 120 percent of the federal mid-term rate published in revenue rulings by the Service. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years.

As a general rule, the fixed amortization and the fixed annuitization methods produce much higher income streams than does the required minimum distribution method. Rev. Rul. 2002-62 allows an investor to make a one-time change in the calculation method. If the investor is using the amortization or annuitization methods, a change to the required minimum distribution method is permitted. Once elected, all subsequent annual withdrawals must be made under required minimum distributions. According to Natalie Choate, the esteemed author of Life and Death Planning for Retirement Benefits, 6th Edition, 2006 individuals desiring greater flexibility and control over the size of income payments, at the cost of greater complexity and risk, will tend to select the joint life and last survivor table; while individuals desiring maximum stability of income unaffected by beneficiary changes, will select either the Uniform or Single Life table. Ms. Choate also mentions that the IRS has allowed SEPP participants to annually recalulate the annuitization or amortization method. This can only be done, however, by applying for a private ruling from the IRS.

Account Balance
The IRS permits flexibility in fixing the anniversary date for determining the IRA account balance. The balance can be set any time from December 31 of the year prior to creating the program up to the date of the first distribution. Once established, the same valuation date is used, when necessary, for determining withdrawals. The same flexibility for determining the valuation date applies when one elects the one time change of computing method to the RMD calculation. An important detail to remember is that the anniversary date determines the five year SEPP tenure requirement if you are withdrawing on a schedule that uses this term. Unsanctioned modifications in the SEPP cannot be made without penalty for five years and one day starting from the anniversary date.

IRA Selection for an SEPP program
You can create an SEPP program on all of your IRAs; on some of your IRAs, leaving the remaining IRAs out of the program; or on a single IRA. Once begun, moving funds from outside the SEPP IRA(s) into the SEPP is a prohibited transaction, as is the act of taking funds, other than the required annual distribution, out of the SEPP. If you are holding multiple funds in the SEPP you can make transfer exchanges between the funds without penalty, and you can also transfer the IRA(s) to another fiduciary without penalty.

Changes Considered Modification of the Program
Ms. Choate lists the following acts which will be deemed modification of the SEPP, triggering penalty taxes (Life and Death Planning, pp 477-78:
 * Stopping the payments;
 * Taking extra payment;
 * Changing the "period" of periodic payments;
 * Additions to the account; transfers into, out of, the account;
 * Changing how the payments in the series are determined.

Using an SEPP for Charitable Donations
If you have sufficient wealth, are under the age of 59 and 1/2, and are desirous of making charitable donations with retirement plan funds, establishing an SEPP program in order to donate IRA funds to a charity is a valid option.

Links

 * Taking Substantially Equal Periodic Payments - Vanguard Retirement Resource Center
 * 72(t) Calculator: Early withdrawals from retirement accounts
 * Revenue Ruling 2002-62
 * IRS: Retirement Plans FAQs regarding Revenue Ruling 2002-62
 * Index of Applicable Federal Rates (AFR) Rulings