In the early stages of building a career, retirement seems like a vague concept “years away” and often difficult to imagine actually becoming a reality. As the years progress and the birthdays add up, the notion of retirement can quickly sneak up on people, bringing a whole new intensity to the impending reality of retirement. It’s not uncommon for us to work with people who enter their 50s and start to question their life-long default notion of retiring “at 65,” and with this shift in mindset comes conversations on options for navigating this dynamic landscape. One such option is the concept of Substantially Equal Periodic Payments (SEPP), also known as 72(t) payments, which can provide much-needed flexibility. This is a potentially helpful, but complicated strategy, to unlock retirement savings prior to reaching the age of 59 ½, the standard age for distributions from retirement accounts without penalty. In short, SEPP allow for the meaningful advantage of avoiding the 10% early withdrawal penalty. (Please Note: This is different than the other rule permitting employees who separate from service during or after the year they turn age 55 to access funds from the plan of the employer without penalty.)
When interest rates were low for so long back in the “old days” of 2021, these calculated payments became an afterthought because they typically weren’t large enough to be meaningful. Yet another impact of recently higher interest rates is the higher calculated amounts of these 72(t) payments. For this reason, the 72(t) strategy is worth revisiting if flexibility around early retirement is a goal.
All this being said, it must be emphasized that implementing a SEPP strategy is a complex tool that should only be undertaken in very specific circumstances and with professional guidance for compliance with tax rules and, more importantly, alignment and coordination with the broader wealth plan.
How do SEPP work?
At its core, SEPP is essentially the deliberate creation of a systematic sequence of substantially equal periodic payments from retirement accounts. By doing this, individuals can access their retirement funds earlier than age 59 1/2, all while mitigating the standard 10% early withdrawal penalty. Crucially, this approach necessitates strict adherence to specific conditions, with a central requirement that the SEPP program must be maintained for a minimum of five years or until the account holder reaches the age of 59 1/2, whichever time frame is lengthier. By adhering to these criteria, individuals can enjoy the flexibility of access to cash flow (while taxable) without the punitive 10% penalties.
The types of retirement accounts available for Substantially Equal Periodic Payments (SEPP) include Traditional IRAs, 401(k)s, 403(b)s, and the Thrift Savings Plan (TSP). In addition, SEPPs can be set up for SEP IRAs, SIMPLE IRAs and Solo 401(k)s.
Why Use A SEPP?
In a word, flexibility. As noted above, thinking about career plans in your 30s differs vastly compared to your 50s–life happens. Having access to what is usually an individual’s largest pool of capital can open doors to new opportunities: changing careers, handling serious health issues, or in the best case, retiring early to pursue other meaningful endeavors. With the recent IRS notice 2022-6 setting a new “floor” interest rate of 5% for calculating 72(t) payments (up from only 120% of what was a very low applicable federal mid-term rate), these payments can positively and substantially impact cash flow.
Defining the Calculation Methods
SEPP payments can be calculated using three distinct and IRS-approved methods, each carefully tailored to accommodate varying financial objectives. The methods are complex and beyond the scope of this article, which underscores our recommendation to always seek sound tax advice if pursuing this plan. That said, below are the main ideas behind each method:
- Required Minimum Distribution (RMD) Method: With this approach, individuals can use the IRS's Uniform Lifetime Table, Joint or Single Life Expectancy Table (note this is NOT an actual RMD that is mandated when people turn 73). Each year, you divide the prior year ending account balance by the life expectancy factor from the IRS Table (found in IRS Publication 590-B) that corresponds to the taxpayer’s age. This method typically results in a lower maximum payment amount, and like traditional RMDs, this amount varies from year to year as account balances change. This method must be used for the entirety of the distribution period and cannot be changed once initiated.
- Fixed Amortization Method: Under this method, SEPP payments are determined through a specialized amortization formula, incorporating both life expectancy and an assumed interest rate. Importantly, the chosen interest rate can be the higher of 5% or must not exceed 120% of the federal mid-term rate (4.09% as of August 2023). Again, the higher the interest rate, the higher the distribution amount, and this method (using the Single Life Expectancy table) consistently yields the highest annual distributions. The amount calculated at the beginning of the distribution period will remain level from year to year.
- Fixed Annuitization Method: Similar to the Fixed Amortization approach, this method leverages an annuity factor that is tied to the account holder's age and the aforementioned designated interest rate. These components come together to calculate consistent annual payments which approach, but not quite equal, the Fixed Amortization Method. Like the Fixed Amortization Method, the distribution amount calculated at the beginning of the distribution period will remain level from year to year.
Key Tax Considerations and Pitfalls:
Regardless of the age at which you start taking SEPP, the distributions are considered taxable income. This means they will be subject to federal and in most cases, state income tax. Of course, the exact amount of tax you'll owe depends on your total income and tax bracket. But beyond the standard taxable income, some other key considerations include:
- Adherence to Regulations: SEPP mandates unwavering adherence to the regulations. Any deviation from the predefined payment schedule carries the potential to trigger retroactive penalties and interest, underscoring the importance of meticulous planning and execution. (Note: One significant mandate is that no contributions or rollovers into or out of an IRA may take place during the 72(t) time period. Otherwise, this would be deemed a modification of the payment schedule and would trigger a retroactive 10% penalty plus interest!)
- Tax Reporting: Each year, you'll receive a Form 1099-R from your retirement account custodian showing the total distributions for the year. This amount must be reported on your tax return. It's important to indicate on Form 5329 that the distributions are part of a SEPP program to avoid the 10% early withdrawal penalty.
- Potential Underpayment Penalties: If the SEPP schedule is modified and the 10% penalty is retroactively applied, you could also face penalties for underpayment of tax in the years the distributions were taken. This is because the additional tax from the 10% penalty should have been included in your tax payments for those years.
- Tax Projections Even More Important Now: Because SEPP distributions increase your taxable income, they could potentially affect marginal tax rates, capital gains tax rates, eligibility for certain tax credits, and deductions that are phased out at higher income levels.
As always, tax laws can be complex, the consequences of mistakes can be costly, and everyone’s situation is unique. So, it's crucial to coordinate and consult with a tax professional to understand the potential tax implications of a SEPP program with attention to detail.
While SEPP can be a helpful financial tool, it is imperative to be acutely aware of potential considerations:
- Impact on Retirement Portfolio: Depending on the selected calculation method, SEPP distributions could potentially outpace the actual growth of the retirement account. This scenario raises the possibility of depleting savings at a faster rate than initially anticipated. The SEPP plan must be put in context of the broader financial retirement and cash flow plan because in the absence of other strategies (starting a business, taking a new job) the SEPP is draining retirement assets.
- Splitting Up Accounts for Isolated Distribution Targets: Since the calculated distribution amounts could result in too much taxable cash flows, individuals can actually split an IRA (for example) into multiple IRAs and choose only one of the IRAs to zero in on desired 72(t) payments. Taxpayers can certainly take smaller than calculated distributions on an entire account, but this then encumbers that IRA to be subject to the 72(t) schedule. By segmenting out a separate account, the account wouldn’t be constrained by the 72(t) schedule.
- Market Volatility Consideration: Calculation methods, such as Fixed Amortization and Fixed Annuitization, lack the built-in capacity to adjust for market fluctuations. Consequently, there exists the potential for misalignment between SEPP payments and the actual market-driven values of the retirement account.
- Unique Scenarios: SEPPs can get very complex when other variables are factored in. Situations such as divorce, death, and disability all complicate these plans and need to be accounted for.
In almost all cases, we believe retirement accounts should remain fully invested, monitored, maintained, and left to grow over time. Tapping these accounts early should be a rarity and only explored in special circumstances. However, as interest rates have increased over the past year, Substantially Equal Periodic Payments (SEPP) have become a more viable strategy for individuals to consider in unlocking the flexibility of retirement funds sooner while avoiding the burden of penalties. However, the nuanced realm of SEPP necessitates planning, professional guidance, and steadfast compliance with IRS regulations. Most importantly, a strategy like this must be placed in the context of a family’s broader wealth plan in order to ensure these types of distributions, while interesting, don’t derail goals and aspirations.
Disclaimer: Johnson Investment Counsel cannot promise future results. Any expectations presented here should not be taken as any guarantee or other assurance as to future results. Our opinions are a reflection of our best judgment at the time this material was created, and we disclaim any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise. Johnson Investment Counsel does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Johnson Investment Counsel cannot promise future results. Any expectations presented here should not be taken as any guarantee or other assurance as to future results. Our opinions are a reflection of our best judgment at the time this material was created, and we disclaim any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise. Johnson Investment Counsel does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.