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. Failure to maintain payments results in the imposition of the penalty tax for early 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 a penalty tax. Thus if an individual establishes an SEPP at age 57, any lump sum withdrawals before age 62 will trigger the penalty tax, even if it occurs after age 59 and 1/2. SEPP withdrawals are filed on IRS Form 5329.

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.

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.

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