Substantially Equal Periodic Payment (SEPP): Learn The Rules

If you have assets in an IRA , qualified retirement plan or 403(b) account, your intentions may be to defer taking distributions until after you reach age 59.5, when the early distribution penalty would not apply. However, unexpected financial hardships may force you to withdraw assets prematurely. If you withdraw these assets while under the age of 59.5, you may owe ordinary income tax on these amounts, plus an additional 10% early distribution penalty unless an exception applies. One of the exceptions to the early distribution penalty is taking assets under a substantially equal periodic payment (SEPP) program.

SEPP programs are not permitted under employer-sponsored qualified plans or 403(b) accounts while you are still employed by the employer that sponsors the plan. If you own an IRA, you may start a SEPP program under the IRA at any time while you are under the age of 59.5. (To learn more about SEPPs, see Tax-Saving Advice For IRA Holders and Taking Penalty-Free Withdrawals From Your IRA)

If your financial need is short term, you may want to consider other alternatives since you are required to continue the SEPP program for a minimum of five years. This period may be much longer if you are younger than 44 years old. This is because the IRS requires you to continue the SEPP program for five years or until you are 59.5, whichever comes last. The following two examples illustrate this rule.

Example 1
Jane, who is 35 years old, begins a SEPP program on her retirement account. Jane is required to continue the SEPP program until she reaches age 59.5, which is in 24.5 years. (For Jane, age 59.5 comes after five years).

Example 2
Harry started his SEPP program at age 57. Harry's program ends in five years, at which time he will be 62 years old. For Harry, five years come after he reaches 59.5.

If you terminate your SEPP before the deadline, you will be required to pay the IRS all the penalties that were waived on amounts taken under the program, plus interest. The IRS allows an exception to this rule for taxpayers who terminate the program because they become disabled, die or the retirement assets under the SEPP are depleted due to loss in market value. (For more insight, see What are the "certain requirements" that must be met for SEPPs?)

The IRS provides three methods to calculate SEPPs. Because the three methods result in different calculated amounts, you can choose the one that better suits your financial need. These methods are the following:

• Amortization Method
  Under this method, the annual payment, which is the same for each year of the program, is determined by using the life expectancy of the taxpayer and his or her beneficiary, if the taxpayer has one, and a chosen interest rate.
• Annuitization Method
  Similar to the amortization method, the amount under this method is the same each year. The amount is determined by using an annuity based on the taxpayer's age and the age of the beneficiary, if applicable, and a chosen interest rate. The annuity factor is derived using an IRS-provided mortality table.
• Required Minimum Distribution (RMD) Method
  The annual payment for each year is determined by dividing the account balance by the life expectancy factor of the taxpayer and beneficiary, if applicable. Under this method, the annual amount is required to be figured again each year, and, as a result, will change from year to year. This method takes into account market fluctuation of the account balance.

Let's take a look at an example that demonstrates the amounts that result from each method:

Example 3
Suppose that John is 45 years old. He wants to start a SEPP program on his retirement account balance of $500,000. For the amortization and annuitization methods, he will use an interest rate of 3.98%. He has no beneficiary for his IRA, so he will use only his life expectancy. The results are as follows:

• Amortization method: $25,511.57 per year.
• Annuitization method: $25,227.04 per year.
• Minimum distribution method: $12,886.60 per year.

John\'s financial need will determine his choice of method.

Tip: John has the option of transferring a portion of his IRA to a separate IRA and calculating the SEPP based on that amount. This is usually done for taxpayers who want to withdraw lower amounts than what the original IRA balance provides. For instance, if $200,000 is sufficient to provide the payment amounts that he needs, he can transfer that amount to a separate IRA and take the SEPP amounts from that IRA.

Before 2002, some taxpayers who elected to use the annuitization or amortization method found that their retirement account balances were depleting much faster than projected. This was attributed to poor market performances. Under old rules, payments were required to be made under the method selected at the beginning of the program despite the fact that such payments could result in a depletion of the retirement assets. Recognizing that these individuals needed some reprieve to preserve the retirement assets for their retirement years, the IRS issued Revenue Ruling-2002-62 in October 2002, wherein they provide that taxpayers using either the annuitization or amortization method could make a one-time switch to the RMD method. This switch would result in the SEP amount being much lower.

If you are already on a SEPP program using the amortization or annuitization method, and want to change to the RMD method, consult with your financial professional.

Under Revenue Procedure-2002-62, the IRS explains that any of the three life-expectancy tables provided in the final RMD regulations may be used to calculate SEPP payments. These three tables are the "Single Life-Expectancy Table", the "Uniform Table" and the "Joint Life-Expectancy Table". Generally, your choice of table is determined by whether you have designated a beneficiary of your retirement account. Your financial professional should be able to assist you in choosing the right table.

If you are using the joint life expectancy tables to calculate your SEPP, your beneficiary is determined on January 1. Therefore, if you changed your beneficiary during the year, be sure to inform your financial professional so that he or she can use the right life expectancies. Also, if you have multiple beneficiaries, the oldest beneficiary's life expectancy is used to calculate your SEPP.

To calculate your SEPP payment for the year, you will use the life expectancy of the beneficiary who was on your retirement account as of January 1 of the year for which the calculation is being done. Any change made after January 1 is taken into consideration the following year, provided the change is still in effect at the beginning of that year. (For additional insight, check out Do I have to continue SEPPs for an inherited IRA?)

Each month the IRS issues a revenue ruling in which certain interest rates are provided. One such rate is the federal mid-term rate. According to Revenue Ruling-2002-62, a taxpayer should use a rate of up to 120% of the federal mid-term rate to calculate SEPP amounts under the amortization and annuitization methods.

Once you start a SEPP program on a retirement account, you may not make any additions to or distributions from the account. Any changes to the account balance, with the exception of the SEPPs and required fees, such as trade and administrative fees, may result in a modification of the SEPP program and could be cause for disqualification by the IRS. As explained earlier, any disqualification will result in an assessment of penalties and interest. (Find out more about this in Can I make additional withdrawals from my IRA without tax penalty?)

The IRS guidelines for determining the account balance to use in the SEPP program provide much flexibility. Should you decide to change the calculation method for your existing SEPP or start a new SEPP program, be sure to consult with your tax professional regarding the account balance that should be used in the calculation. As with any issue pertaining to retirement plans, you must be sure to seek competent tax-professional assistance to ensure that you operate within the parameters of the regulations.

Note: Revenue Ruling-2002-62 is effective for years beginning 2003 (was optional for year 2002).

Taxpayers often make costly mistakes with SEPP programs because there is little guidance on what can be done in certain situations. For instance, if the individual misses a SEPP distribution deadline or distributes too much, the IRS may make an exception depending on the circumstances. In cases where guidance is needed, consider working with a tax professional who has experience dealing with the IRS on SEPP issues. A few of these individuals have been able to convince the IRS not to assess penalties, where they would otherwise apply.