A Series of Fortunate Events; Tread Lightly - (72(t) Payments/Substantially Equal Periodic Payments)
By Jeremy T. Rodriguez, JD
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Most people know that, generally speaking, you cannot access traditional IRA money penalty-free until you reach age 59 ½. Early distributions are subject to a 10% early withdrawal penalty. Of course, like virtually every other retirement rule ever written, there are exceptions to this general rule. One of those exceptions is called the Series of Substantially Equal Periodic Payments (“SEPPs”) or 72(t) payments (named after the tax code section where the exception can be found). If you comply with all the rules, you’ll experience a series of fortunate events; annual distributions that do not trigger the 10% early withdrawal penalty!
One of the strictest rules involves the prohibition on modification. With limited exceptions, the distribution method selected at the beginning of the payment stream cannot be changed until the end of the payment term. This means you cannot increase or decrease the installment payments. Moreover, you cannot “modify” the account balance. In other words, you cannot make contributions or rollover money, both to and from, the IRA used in calculating the SEPP/72(t) payments. In fact, the only additions that are allowed to the account are investment gains and losses. Finally, in most cases, you can also not take additional withdrawals from the account used in calculating the SEPP payments.
These restrictions stay in place until the end of the payment term, which is the later of (A) 5 years or (B) the IRA owner reaching age 59 ½. So, for example, an IRA owner that began SEPPs at age 40 would have to abide by the restrictions for almost 20 years! On the other hand, an IRA owner that begins SEPPs at age 58 would only have to continue until age 63. Importantly, this five year time-period is measured from the date of the first distribution and ends exactly five years from that date. It does not end after the fifth distribution is made.
This issue was actually settled at the expense of a taxpayer in a landmark case involving § 72(t). Mr. Arnold began a 72(t) payment schedule in December when he was age 55. Because of his age, his payment plan needed to stay in place for 5 years (remember, the rule is the later of). Over the next four years, Mr. Arnold took an annual distribution each January of $44,000 to satisfy his payment schedule. During the final year, he took his annual January distribution, but he also took an additional distribution in November, one month before the fifth anniversary of his initial SEPP distribution. The IRS held that the extra distribution was a modification of his payment plan and assessed the 10% penalty on all prior distributions! At trial, the Tax Court sided with the IRS and Mr. Arnold was forced to pay the 10% penalty plus interest on all prior SEPP payments made before he reached age 59 ½.
As you can see, not following the SEPP rules to a “t” results in some heavy consequences; all of the previous SEPP payments made prior to age 59 ½ are subject to the 10% penalty tax, plus interest on the back payments. If the SEPP plan was in place for some time, or if the annual distributions are substantial, the resulting tax bill for non-compliance could be huge!
All too often, people find that subsequent life events alter the need for SEPP distributions. For some, the SEPP distributions, when combined with other monies, produce greater income (and a larger tax liability) than they anticipated. However, the flipside is worse. Imagine being a taxpayer who later determines that the SEPP distributions are not great enough to meet financial needs. Not only is this person stuck with the distribution plan, but they don’t have the same flexibility with the IRA account they would have had if the SEPP/72(t) distributions had never begun!
Adopting a SEPP payment plan is a big commitment that involves complex rules and huge penalties for making a mistake. The rules discussed here are only a penny in a pocketful of change. Therefore, you really need to consult with a knowledgeable tax and/or financial advisor before you engage in a 72(t) payment plan.