Substantially Equal Periodic Payments

Substantially Equal Periodic Payments (SEPP), also known as 72(t) distributions, are a provision in the United States tax code that permits individuals to withdraw funds from their retirement accounts before the age of 59½ without incurring the usual 10% early withdrawal penalty.

SEPP can serve as a bridge to supplement income before individuals become eligible for other income sources, such as Social Security benefits or other retirement accounts that have penalties for early withdrawals. It can help individuals meet financial obligations or cover living expenses during a transitional period.

• Substantially Equal Periodic Payments (SEPP) refers to a policy of the Internal Revenue Service (IRS) that allows individuals to withdraw funds from their retirement accounts, such as an Individual Retirement Account (IRA), before the age of 59½.
• These payments are calculated using IRS-approved methods, such as the Required Minimum Distribution (RMD) method, fixed amortization method, or fixed annuitization method.
• The purpose of SEPP is to provide individuals with a way to have access to their retirement funds without the stress of penalty before they reach the standard retirement age.

Substantially Equal Periodic Payments (SEPP) let individuals withdraw funds from their retirement accounts before they turn 59½ without having to pay the usual withdrawal penalty.

To be eligible for SEPP, individuals must have funds in a qualified retirement account. Examples are a traditional IRA (Individual Retirement Account) or a 401(k) plan. SEPP does not apply to Roth IRAs since contributions to Roth IRAs are made with after-tax dollars and are generally not subject to early withdrawal penalties.

Methods

Once eligible, an individual needs to choose one of the three IRS-approved techniques to calculate substantially equal periodic payments:

1. Required Minimum Distribution (RMD) method: This method uses a person's life expectancy to calculate annual withdrawals based on the account balance and an IRS life expectancy table. The payments can fluctuate each year based on changes in your account balance.
2. Fixed Amortization method: This method calculates fixed annual payments over a specified number of years based on an individual's account balance and an interest rate determined by the IRS.
3. Fixed Annuitization method: This method calculates fixed annual payments based on account balance, an interest rate determined by the IRS, and life expectancy.

Once a method is chosen, the individual or their financial advisor can calculate the amount of the substantially equal periodic payments using the specific formula for the selected method. Factors such as the individual's age, life expectancy, account balance, and the chosen interest rate are taken into account.

After initiating SEPP, the individual must continue receiving substantially equal periodic payments for at least five years or until reaching the age of 59½, whichever is longer. Making modifications to the payment schedule or ceasing withdrawals before the required period can result in the retroactive application of the 10% early withdrawal penalty on all previous distributions.

While SEPP exempts individuals from the early withdrawal penalty, they still have to pay the ordinary income tax for receivable funds. Each payment received is included in the individual's taxable income for the year. Proper tax planning is necessary, and consulting with a tax professional is advisable to understand the tax implications of SEPP in the individual's specific situation.

One can take the following steps to calculate the Substantially Equal Periodic Payments (SEPP) for an individual:

• Determine the individual's age: The individual's age is a crucial factor in the SEPP calculation.
• Select an approved method: Choose one of the three approved methods for calculating SEPP: Required Minimum Distribution (RMD) Method, Fixed Amortization Method, or Fixed Annuitization Method.
• Gather necessary information: Obtain the individual's retirement account balance and the applicable interest rate.
• Calculate the annual withdrawal period: Use the chosen method and the individual's age, to determine the number of years for which the annual withdrawals must be made. This period should be at least five years or until the individual reaches the age of 59 ½, whichever is longer.
• Calculate the annual withdrawal amount: Apply the selected method to calculate the annual withdrawal amount. The formulas and factors used in each method differ. For example, the Fixed Amortization Method involves dividing the retirement account balance by the withdrawal period.
• Review and finalize: Ensure that the calculated SEPP amount meets the requirements of the Internal Revenue Service (IRS) guidelines. It is advisable to consult with a qualified financial advisor or tax professional to ensure accuracy and compliance with applicable regulations.

Let us look at the substantially equal periodic payments examples to understand the concept better -

Example #1

Suppose Sarah is 48 years old and has a retirement account balance of $450,000. The current interest rate for SEPP purposes is 3.5%.

Determining the annual withdrawal period:

Based on Sarah's age, the IRS Single Life Expectancy Table suggests a life expectancy factor of 36.7 years. Sarah needs to make withdrawals for at least five years or until she reaches 59 ½, whichever is longer. Hence, the withdrawal period would be 36.7 years.

Calculating the annual withdrawal amount using the Fixed Amortization Method: Sarah's retirement account balance is divided by the withdrawal period. In this case, $450,000 divided by 36.7 equals approximately $12,267.90 per year.

Therefore, Sarah would need to take annual withdrawals of approximately $12,267.90 from her retirement account under the SEPP arrangement to avoid the early withdrawal penalty. It's important to note that this is a hypothetical example, and actual calculations may vary based on factors such as age, account balance, interest rates, and the IRS (Internal Revenue Service) guidelines.

Example #2

Let's consider an individual named Lisa, who is 55 years old and has a retirement account balance of $800,000. The current interest rate for SEPP purposes is 4.25%.

1. Determining the annual withdrawal period: Using the IRS Single Life Expectancy Table, the life expectancy factor for a 55-year-old individual is approximately 29.6 years. Since Lisa needs to make withdrawals for at least five years or until she reaches 59 ½, whichever is longer, the withdrawal period would be 29.6 years.
2. Calculating the annual withdrawal amount: Using the Fixed Annuitization Method, Lisa's retirement account balance is divided by the withdrawal period. In this case, $800,000 divided by 29.6 equals approximately $27,027 per year.

Therefore, Lisa would need to take annual withdrawals of approximately $27,027 from her retirement account under the SEPP arrangement to avoid the early withdrawal penalty.

The advantages and disadvantages of substantially equal periodic payments are as follows:

Advantages

• The primary benefit of SEPP is the ability to withdraw funds from retirement accounts before the age of 59 ½. It can be done without incurring the early withdrawal penalty, which is typically 10% of the withdrawn amount. SEPP allows individuals to access their retirement savings for specific purposes. This could be early retirement, medical expenses, or educational expenses, without facing this penalty.
• SEPP provides flexibility in terms of the withdrawal amount and frequency. Depending on the chosen method (RMD, Fixed Amortization, or Fixed Annuitization), individuals can customize the periodic payments to fit their financial needs. They can choose annual, monthly, or other intervals for withdrawals, providing them with a steady income stream.
• While individuals are making SEPP withdrawals, the remaining funds in the retirement account can continue to grow on a tax-deferred basis. This allows for potential investment gains and compounding over time, which can be advantageous for long-term retirement planning.

Disadvantages

• Once SEPP is initiated, individuals must adhere to the chosen method and withdrawal schedule for the required period. This is typically five years or until reaching age 59 ½, whichever is longer. This lack of flexibility can be a disadvantage if there is a change in financial circumstances. The same can happen if the individual requires additional funds beyond the predetermined withdrawals.
• SEPP also restricts the amount that can be withdrawn annually based on specific calculations. This limitation may not provide sufficient funds for certain financial needs or emergencies that may arise.
• Depending on the chosen SEPP method, the calculated annual withdrawal amount may not align with an individual's financial requirements or lifestyle. If the withdrawals are too low, it could result in an inadequate income stream. This can lead to financial strain or the need to tap into other resources.

This has been a guide to What are Substantially Equal Periodic Payments. We explain how to calculate it, its examples, advantages, and disadvantages. You can learn more about it from the following articles –

• Personal Finance
• Finance Charge
• Personal Exemption