“Substantially equal periodic payments are one option available to those who really need to tap their IRAs early. However, be aware that it can be a complicated process, and it could be easy to make a costly mistake. Therefore, only use this strategy if absolutely necessary, and get some help while you're at it.”
Unless you’re thinking of retiring early, it’s unlikely you’ll hear about the possibility of using something called a “series of substantially equal periodic payments”—or a 72(t) payment strategy—to take penalty-free withdrawals from your IRA before age 59½.
Kiplinger’s recent article, “Retiring Early? Ways to Help Avoid Early Withdrawal Penalties on Retirement Accounts,” says there’s no reason to delve into this, unless it’s absolutely necessary because the calculations can be complex. There are many ways to mess it up, and if you get it wrong, the penalties can be huge.
Typically, anything an account owner withdraws from a traditional IRA or any other tax-deferred retirement plan before turning 59½, is considered an early or “premature” distribution by the IRS. In addition to paying federal income tax on the withdrawn amount, you have to also pay a 10% early withdrawal penalty—unless an exception applies. The section of the Internal Revenue Code that discusses many of these exceptions—including death, disability, or using the money for educational purposes, or as a qualified first-time home buyer—is Section 72(t).
Section 72(t)(2)(A)(iv) describes the exception that lets you to use a series of substantially equal periodic payments (SEPPs) based on life expectancy to withdraw money from your IRA or 401(k) for a minimum of five years, or until you reach age 59½, whichever is later. If you began at 58, you’d still be required to continue payments for five years, or until you reach age 63.
A “substantially equal periodic payment” is the specific amount you’ll withdraw every year from your IRA or 401(k). This amount won’t necessarily be precisely the same every year, depending on the method you select, but it must meet the IRS definition of “substantially equal.”
Payments are based on life expectancy and they can be calculated using one of three IRS-approved methods: the required minimum distribution (RMD) method, the amortization method, or the annuitization method. Each method produces a different result. Make the election with care, because once you decide on the method for calculating the amount, you’ll have to stay with it unless you decide to switch to the RMD method. In that case, you can make a one-time change.
Another rule is that withdrawals must be from the same IRA account every time. If you don’t want to tie up an entire IRA in this, use a direct rollover to split one IRA into two before beginning. However, you must always use the same IRA for those periodic payments you get.
It’s not hard to make a mistake. The IRS isn’t real forgiving, if you miscalculate or modify your payments, or if you don’t adhere to your payment plan. If you mess up, you’ll no longer be eligible for the exemption from the 10% early withdrawal penalty. It is also retroactive. As a result, you’ll also be penalized for all the withdrawals you took before turning age 59½. Any changes to the IRA’s balance (other than normal gains and losses and your SEPPs) also will trigger the 10% penalty.
If you have a 401(k), and you’re in the calendar year that you turn 55 or later when you experience a “separation from service” (leaving an employer because you’re retiring, quitting, taking a buyout, were fired, or laid off), you’re not required to pay the early withdrawal penalty on distributions from that employer’s plan.
This is a less complicated exception to the penalty on early distributions than taking SEPPs. However, if you roll over the 401(k) to an IRA, any distribution from that IRA can be penalized. Therefore, don’t move the money until you’re certain about whether you’ll need it. Either way, you’ll still have to pay income tax on any distributions. Consider this point as you decide, unless you decide to move to the RMD method. That’s a change you can only make one time.
Reference: Kiplinger (October 11, 2019) “Retiring Early? Ways to Help Avoid Early Withdrawal Penalties on Retirement Accounts”