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Tax rules can help you save money for retirement, but there are certain strings attached when you've put your money in pre-tax accounts. That's especially true if you retire at a relatively young age and want to take distributions. For example, if you need to tap retirement savings for cash flow before age 59½, you risk paying an early withdrawal penalty.
Fortunately, there may be ways you can access your money early and avoid tax penalties. Substantially equal periodic payments might be an option for you.
What Is a Substantially Equal Periodic Payment Plan?
A series of substantially equal periodic payments, also known as a SEPP plan, enables you to withdraw money from pre-tax retirement accounts — such as a traditional 401(k) or individual retirement account (IRA) — while avoiding early withdrawal penalties.
When you add money to retirement accounts, you might expect to leave the money in those accounts for a long time. For most people, retirement comes after age 59½, and there's little risk of needing to pull money out of pre-tax retirement accounts before then. But life can surprise you. You may need to access your savings earlier than you originally intended.
Unfortunately, you will incur a tax penalty if you withdraw pre-tax money from a retirement account before age 59½. That penalty is 10% of your gross distribution, which ultimately reduces what remains for spending.1
However, there are several exceptions to the early withdrawal penalty, including:
- Death or disability of the account owner
- Higher education expenses
- Medical expenses that exceed specific thresholds
- A SEPP plan
While there are other, less common exceptions, SEPP plans deserve consideration.
By arranging a SEPP program, you can potentially avoid those early withdrawal penalties on pre-tax distributions. In short, they way they work is that you figure out an amount to withdraw each year, and you take a distribution that matches that amount — no more and no less.
To use the SEPP exception, you establish a series of payments from your IRA that meets specific IRS requirements. The rules are somewhat rigid, and a long-term commitment is critical. You must continue the payout under a SEPP plan for at least five years or until you reach age 59½ — whichever is later — and deviating from the plan can be problematic.2 If you don't follow through, the IRS can retroactively charge all of the early withdrawal penalties you previously avoided, and you may even owe interest on those penalty charges. That can happen if you fail to follow the SEPP for the full five years or if you withdraw more than your scheduled payment.
However, some minor changes are allowed. You can switch from the amortization or annuitization method (described below) to the required minimum distribution method one time during your lifetime if needed. That might make sense if you find that you're getting more money from the SEPP plan than you need each year.
Note that while this strategy helps you avoid penalty taxes for early withdrawals, it does not eliminate income taxes. Any distributions you take from pre-tax retirement accounts are most likely taxable as ordinary income. A SEPP does not change that. You generally have to report pre-tax withdrawals on your income tax return — whether you take them before or after age 59½.
How a SEPP Plan Works
A SEPP plan that helps you avoid penalties must satisfy IRS rules spelled out in Section 72(t).2 To create the plan, you choose a method of calculating your payments. The payment amount depends on several figures, including an interest rate and a life expectancy table. The info needed is provided by the IRS, and you have some flexibility when choosing how to set up your payment plan.
For example, you can choose from different life expectancy tables. You might choose the Uniform Lifetime Table or the Single Life Expectancy Table depending on which one is better for your situation. And if you have a beneficiary on your account, you may be able to use the Joint Life and Last Survivor Expectancy Table, taking into account the age of your IRA's beneficiary.
Ultimately, you'll arrive at an annual amount that you must distribute from your account each year. You're allowed to split the distribution into monthly payments (or use another frequency) if you prefer. What matters most is that your annual distribution matches the amount you calculate for your SEPP plan. Using a retirement income calculator can help.
There are three methods for calculating your payment. Each results in a different annual distribution:
Required Minimum Distribution Method
This provides the smallest annual payment of the three approved calculation methods. To calculate your payment, divide your account balance by your remaining life expectancy (from the IRS-approved life expectancy table of your choice). Each year, you'll refresh the calculation based on your account balance and updated life expectancy. As a result, the amount you withdraw each year varies.
Fixed Amortization
With this approach, your distributions don't change from year to year. The amount you withdraw is designed to deplete your beginning account balance over your remaining life expectancy (and a joint annuitant's life, if applicable). To calculate your fixed amortization payment, you use your life expectancy combined with an IRS-approved interest rate.
Out of all three allowable methods, amortization typically produces the highest annual withdrawal amount. However, if your account experiences unusually rapid growth, it may be possible for payments under the required minimum distribution method to eventually outpace payments from the amortization method.
Fixed Annuitization
This method also results in the same payment every year. To calculate this payment, you use an annuity factor supplied by the IRS along with an appropriate interest rate to determine the annual amount.
Which Method Is Best?
The right choice depends on several factors. It's wise to review your options carefully with a tax professional before making a decision. You might consider your expectations for growth inside of your retirement account as well as other sources of income that supplement your withdrawals.
Also, consider whether you want to maximize your withdrawals or keep them to a minimum. With a clear idea of your needs and all of the moving parts, you can decide which method to choose.
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Pros & Cons of SEPP Plans
If you're not yet 59½, a SEPP can enable you to access money that would otherwise be tied up in pre-tax retirement accounts. That's helpful when you've been a diligent retirement saver but lack liquid cash for immediate needs. Without the 72(t) rules, you would likely face additional tax penalties, making it harder to reach your financial goals.
SEPP Plans Can Be Restrictive
This strategy can be far from ideal. The rules are rigid, and you may need to stick with the program for an extended period. For example, if you're currently 50 years old, you'll have to take those distributions without fail at least until you reach age 59½. And, again, you must take the exact amount required from your account every year — not a dollar more or less. But, if you're currently, say, 57 years old, you'd need to follow the program beyond age 59½ to satisfy the five-year minimum. That might result in more withdrawals from tax-protected accounts than you'd like.
It's important to recognize that a SEPP plan effectively locks up the account you earmark for these withdrawals. You won't be able to contribute to the account anymore. And if you have additional cash flow needs, such as needing emergency money for a new furnace or vehicle, you can't tap that account without derailing the plan. Deviating from the SEPP puts you at risk for retroactive tax penalties and interest, which can cause minor financial problems to snowball.
Some Parameters Can Create Uncertainty
Moreover, the rules can be confusing, making it easy to trip up. For example, the IRS requires you to wait at least five full years before altering a SEPP plan or taking additional money from your account. So, if you were to begin a SEPP on November 1, 2023, you wouldn't be able to take additional distributions from that account until at least November 1, 2028 — even though you'll take your fifth payment on November 1, 2027. That's not intuitive to most people.
Because a SEPP plan makes your accounts difficult to access, it might make sense to isolate the amount you need and use a dedicated account for these distributions. For instance, you might calculate a dollar amount of desired withdrawals and determine that you need roughly $300,000 to generate those distributions. But if your IRA has $850,000, you'll end up getting more money than you need each year — and you can't get to the extra $550,000 if an emergency comes up without triggering tax penalties. In a case such as that, you might open a separate IRA and fund it with the $300,000 needed for your SEPP. Alternatively, you could transfer the extra $550,000 out to a different IRA so that the money isn't part of the SEPP.
Tapping Money Now Can Reduce Payouts Later
Finally, tapping your retirement savings early may leave you short on money later in life. Your retirement assets may need to support you for several decades in retirement. By beginning withdrawals before age 59½, you extend that period, putting a bigger strain on your investment portfolio. That's not to say that you should never do this, but it's crucial to proceed with caution. When things work well, a large asset base can compound and produce additional resources for your future — and drawing out money early reduces that effect.
Alternative Options Worth Consideration
Before you commit to a SEPP plan, review the details with a financial professional and explore all of the alternatives. A more flexible solution might be available, allowing you to get the money you need without the risks associated with a SEPP plan.
For example, if you leave your job after age 55, you might be able to access money in that employer's 401(k) plan without an early withdrawal penalty. For certain public safety workers, that age goes as low as age 50.
Or, if you're nearing age 59½ and don't need a substantial amount, you could consider spending from savings in your taxable accounts. You might deplete cash reserves with that approach, but you could offset that effect by increasing cash in your traditional IRA. Then, if it turns out that you need additional money, you can reevaluate a SEPP (or other ways of getting that cash). You might even qualify for a different exception at that point depending on the circumstances.
There may be other solutions available as well. Financial professionals and tax advisors can help you evaluate creative ways to follow IRS rules while getting the cash flow you need.
Bottom Line
A SEPP plan can provide helpful access to money that is tied up in pre-tax retirement accounts. That's especially valuable when you retire before age 59½, and you might enjoy early access to your money in other situations. By avoiding early withdrawal penalties, you can potentially save money on taxes (although you'll still owe income tax on most withdrawals).
While it's a stretch to say that these plans are flexible, you have some control over the arrangement. But it's important to understand that this is a long-term commitment, and the consequences of altering the plan can be substantial. As you consider a SEPP plan, review the strategy carefully with a knowledgeable financial professional, and weigh the pros and cons of other funding sources available to you.
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Sources
- Retirement topics — exceptions to tax on early distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.
- Substantially equal periodic payments. https://www.irs.gov/retirement-plans/substantially-equal-periodic-payments.
