April Focus: Substantially Equal Periodic Payments
Generally, distributions from retirement accounts are subject to income tax unless the amount represents after-tax contributions. In addition, individuals who are under age 59 ½ when the distribution occurs are subject to an additional 10% tax (early distribution penalty), unless an exception applies. One such exception is the substantially equal periodic payment (SEPP), commonly referred to as 72(t) after the section of the tax code by which it is governed.
A SEPP is a series of distributions from a retirement account where the amount withdrawn each year generally remains the same for the duration of the SEPP program. There are three IRS approved methods that can be used to compute SEPP distribution amounts:
Under the amortization and annuitization methods, the account is amortized or annuitized over the individual’s life expectancy and the same amount is usually required to be withdrawn from the account each year for the duration of the SEPP. While the RMD method produces a different distribution amount each year, it satisfies the definition of ‘substantially equal’ providing the calculations are done according to IRS guidelines.
A SEPP can be taken from a traditional, SEP or SIMPLE IRA. It can also be taken from a qualified plan such as a 401(k), 403(b) or 457(b) plan after the individual has separated from service with the employer.
A SEPP program must continue for five years, or until the individual reaches age 59 ½, whichever is longer. This means that if someone starts a SEPP at age forty, he will need to continue for at least another nineteen years. Serious consideration must be given to this requirement. An individual should not start a SEPP program if the need for funds is a one-time or short term need. Typically, the ideal SEPP candidate will need the funds for the duration (or most) of the SEPP period.
What Happens if the SEPP is Broken?
The SEPP is considered ‘modified’ if it is terminated before the end of the required payment period, an amount that is more or less than the calculated annual SEPP amount is withdrawn from the account for the year, or if additional assets are added to the account after the SEPP has begun. A modification generally results in the individual being required to pay the 10% early distribution penalty retroactively on all distributions that were taken prior to age 59 ½ under the SEPP program, plus any IRS assessed interest.
When can Payments be Stopped?
Payments can be stopped due to the death or disability of the account owner. They can be modified by changing from the annuitization or amortization methods to the RMD method. If the account balance is not large enough to make the payment due for the year, the account balance can be depleted, thus terminating the SEPP; this can be done regardless of how long the SEPP has been in effect.
Individuals who want their SEPP amounts to be less than what an account produces can split the account so that only the desired amount remains in the account designated for the SEPP. An easy way to do this is to use the amount needed for each year and work backwards to determine the account balance needed to produce the desired amount. This is referred to as a reverse calculation. For instance, if an account produces an annual distribution of $100,000, but the individual needs only $40,000, the reverse calculation can be used to determine the account balance that is needed to produce $40,000 per year. Then an account is established that holds that amount only. A reverse SEPP calculator is available at www.72t.net.
Approach a SEPP with Extreme Caution
A SEPP program seems simple enough on the surface to embolden even the most timid of individuals that they could effectively establish and maintain such a program on their own. But, as is evidenced by the high levels of confusion over the rules and mistakes experienced by individuals posting on the message boards at www.irahelp.com and www.72t.net, taking on a SEPP without expert help is risky business.
Starting a SEPP program requires careful consideration. If the financial need is short term, the individual may want to look to other sources to fill the need or even consider taking the funds from the IRA and paying the early distribution penalty. Individuals should work with a financial or tax professional who is experienced in the area of SEPPs.
For more on SEPPs, visit www.72t.net
Explanations of the rules that govern IRAs are usually provided in Ed Slott’s IRA Advisor Newsletter. If you are not already a subscriber and want to get an idea of the content of the newsletter, you can preview past issues before subscribing.
Question of the Month
Question: I inherited three traditional IRAs and would like to combine them into one inherited IRA. Is that permitted?
Answer: It depends. Generally, you are permitted to combine the IRAs if you inherited them from the same person. This is because the total amount that you are required to withdraw under the beneficiary RMD rules would be the same whether the accounts are held separately or combined. However, this is not recommended if the life expectancies used to calculate RMD amounts for the accounts are not the same. This would usually occur if:
- You are one of the younger of multiple beneficiaries and separate accounts were not established by December 31 of the year following the year in which the IRA owner died.
- The IRAs are subject to different beneficiary distribution options. This can occur if the IRA owner died before the required beginning date (RBD) and the IRAs are held with different financial institutions where one requires the assets to be distributed under the five year rule while the other allows the distributions to occur under the life expectancy method.
Check the distribution options available under each IRA before combining the balances. Additionally, when moving the accounts, be sure to move them as trustee-to trustee transfers and not as distributions and rollovers, because distributions from inherited IRAs for non-spouse beneficiaries cannot be rolled over.
Highlights from Ed Slott’s IRA Advisor Newsletter - April 2009 Issue
Your April 2009 issue of Ed Slott's IRA Advisor is now available online.
Every advisor has clients who have had their retirement and other savings decimated by market losses or by fraud losses from culprits like Bernard Madoff and others.
The first question most clients will have is how to benefit from these losses by deducting them and reducing their tax bill.
In addition, IRS has issued new rules on how to deduct these losses on returns being filed right now.
Here's what you need to know to help your clients.
Deducting IRA Losses
•6 Tests to Pass
•IRA Withdrawal Caution
•IRA Loss Deduction Rules
•IRA Loss Deduction Examples
•Roth Recharacterization Strategy
•Claiming vs. Deducting an IRA Loss
•IRA Losses Due to Fraud
•New Fraud Loss Guidance Issued by IRS
Guest IRA Expert
Robert S. Keebler, CPA, MST, DEP
Virchow, Krause & Company, LLP
Green Bay, Wisconsin
Investment Fraud Losses
•The Role of the SIPC
•Theft Loss - Tax Code Section 165(c)(2)
•IRA Fraud Victims
•Roth IRA Loss Recovery
•Recouping Fraud Losses
•Advisor Action Plan
To view current and past issues of the IRA Advisor, click the link below to access our "Subscribers Only" section of our website:
http://irahelp.com/newsletter.php (for America Online users)