How taxpayers can tap retirement funds early without penalty
A special method allows early access to funds, but it comes with tight restrictions
In 1974, Congress struck a bargain with American taxpayers. Here’s what Congress basically said in the Internal Revenue Code:
If you save for your own retirement, the government won’t tax you while you earn income on your retirement savings – not interest, nor dividends, nor capital gains. This will allow your nest egg to grow over time, so that when you’re ready to retire, you won’t need to rely as much on Social Security or other government programs.
But – when you retire and start drawing down your savings, the government will tax any distributions. After all, your contributions came from money that was never taxed to begin with (salary deferrals), or contributions that earned you a tax deduction (traditional IRAs). The government will want to recoup its investment in your retirement after having deferred tax on it for so long. It’s only fair.
And there’s more.
If you do crack open your nest egg before it’s time to retire, not only will the government tax the distributions, but you’ll also be penalized. So, do yourself a favor and don’t touch your nest egg until you retire.
Oh, and one more thing.
Congress doesn’t know exactly when you’ll retire, and you probably don’t either, so we’ll just use a nice, round age, like 59½, as the magic number. Once you reach this age, the government won’t penalize you for taking out your retirement savings, even if you haven’t actually retired yet. But if you start drawing down your retirement savings before you reach this age, the government will penalize you an additional 10 percent of the amount that you must report as income.
Life happens, so there are exceptions to the penalty
Despite the good intentions of the Internal Revenue Code, life can get complicated. There are medical bills to pay, college educations to fund, homes to buy, and other major life events, such as disability and job loss. Fortunately, the tax code allows taxpayers to avoid the early withdrawal penalty for these types of expenses.
Another method for people who want penalty-free access to retirement funds
There’s one more exemption that’s unrelated to life emergencies or events: substantially equal periodic payments, or SEPPs – not to be confused with the Simplified Employee Pension (SEP) IRA. The SEPP arrangement could be a way to avoid the 10 percent penalty on an early distribution.
Under this method, if a taxpayer begins and continues to take “substantially” the same distribution every year, for at least five years or until the taxpayer reaches age 59½, whichever is later, the taxpayer won’t owe the 10 percent penalty. Suppose a taxpayer is 50 when she takes her first distribution from a 401(k) account from a former employer. If she decides to take SEPPs, she must continue to take periodic (at least annual) distributions until she is 59½ (the later of five years or reaching 59½). If she is 58 when she takes her first 401(k) distribution, she must continue to receive SEPP distributions until she’s 63.
Here’s an example: Sara is 57, and had vowed years ago to pay for her orphaned young nephew’s college education. Her accountant told her that she could tap into her 401(k) without penalty to pay for college expenses. Unfortunately, Sara’s accountant didn’t realize that the 10 percent penalty exemption for higher education expenses applied only to IRAs, not to qualified plans such as a 401(k).
Sara visited a new accountant and learned that she can avoid the 10 percent penalty, which is more than $5,000, by taking substantially equal distributions.*
While avoiding the penalty sounds attractive, Sara must decide whether she is better off paying the one-time penalty and leaving the money in her 401(k), or beginning a series of payments that will reduce her retirement savings while also increasing her taxable income for at least five years.
How to start the SEPP
Starting the SEPP is easy. In the first year that a taxpayer takes an early distribution, he or she must indicate on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, that he or she qualifies for the exception, as shown below.
The amount of the distribution on line 2 would be accompanied by Code 02 to indicate the distribution was part of a SEPP. The taxpayer would follow the same procedure each year he or she takes a SEPP distribution.
Taxpayer beware! One slip up means total disqualification
While taking SEPP distributions can be a great way to avoid the 10 percent penalty, it comes at a high price. Taxpayers must be careful not to violate any of the SEPP technical requirements (IRC §72(q)(2)(D)). Any violation, including taking a distribution that isn’t considered substantially equal, will result in total disqualification – meaning the taxpayer would owe penalties on all previous SEPP distributions.
Here’s an example: For the past four years, Jon has taken annual distributions of $5,000 from his IRA, in which he had zero basis. Each year, he paid tax on the distribution and reported the exemption on Form 5329. However, in year 5, he took an extra $2,000 from the IRA to make a down payment on a new car.
That was his mistake. Jon substantially increased his distribution amount. Now, he must pay a 10 percent penalty on the $2,000 distribution (as well as the tax) – and a 10 percent penalty on the previous four distributions he took totaling $20,000.
There are three ways to determine the SEPP distribution amount
There’s no special form to take the first SEPP distribution, but there is a process for determining what to take out. Taxpayers can use three methods to determine how much their substantially equal payments should be:
1. Required minimum distribution method
As the name implies, this method is identical to how taxpayers compute their required minimum distributions (RMDs). Under this method, taxpayers must redetermine their payment amount each year, based on:
- The prior year’s ending account balance, and
- The taxpayer’s life expectancy, based on IRS tables
2. Fixed amortization method
Under this method, taxpayers determine their annual payment by amortizing, in level amounts, the account balance over a specified number of years (determined using a life expectancy table and chosen interest rate). Taxpayers determine the payment amount only once, and it stays the same for the entire SEPP period.
3. Fixed annuitization method
Under this method, taxpayers divide the account balance by an annuity factor (determined using a life expectancy table and chosen interest rate). Taxpayers determine the payment amount only once, and it stays the same for the entire SEPP period.
Taxpayers can choose any method, but they can’t change the method during the SEPP period, with one exception: Taxpayers who chose the fixed amortization or fixed annuitization method can permanently switch to the RMD method in any subsequent year without penalty. Once the taxpayer switches to the RMD method, no other changes are allowed to the distribution method used.
More fine print
Here are a few more rules that taxpayers and their advisors should understand before starting the series of payments:
- Once payments start, the account is on lock down. Taxpayers can’t roll over money into or transfer money out of the qualified plan or IRA used for a SEPP.
- If SEPP distributions drain the account, it won’t mean penalties. If the final distribution is less than the calculated payment amount because the account balance is down to zero, there’s no penalty.
- Taxpayers can receive equal payments throughout the year. As long as the taxpayer is receiving the total calculated annual payment, he or she can receive a smaller series of distributions during the year.
The pros and cons
The SEPP method for early distributions can be an excellent way for taxpayers younger than 59½ to tap retirement funds without penalty. But keep in mind that there’s still a price to pay in the form of a smaller nest egg. Each taxpayer must determine how important his or her need is to tap these funds, and carefully follow the rules during the SEPP period so the strategy doesn’t backfire.
*In the example above, Sara’s new accountant also correctly observed that even if Sara had taken the IRA distribution to pay for her nephew’s college tuition, Sara still would still owe the 10 percent penalty. That’s because her nephew doesn’t qualify Sara for the penalty exemption; she would get the exemption only by paying for qualifying educational expenses for herself, her spouse, children, or grandchildren.