Maybe you’ve heard of substantially equal periodic payments, sometimes referred to as SEPP, or maybe more commonly “72(t)” or “72(t) distributions”. Most people probably haven’t, or if they have they have only a vague idea what they are about. It’s something of a complicated topic, but rest assured it can help your early retirement plans in different circumstances.
There are two fundamental dilemmas facing just about anyone who wants to retire early:
- Most people accumulate most of their savings through tax-sheltered retirement plans, and
- If you retire before turning age 59½, you’ll not only pay ordinary income tax on those withdrawals, but you also have to pay a 10% early withdrawal penalty.
Now before we get any deeper into SEPPs, let’s first state that the only way to create a flow of distributions from tax-sheltered retirement plans free from either ordinary income tax or early withdrawal penalties is to set up a Roth IRA conversion ladder. But even that strategy isn’t without tax consequences. In effect, you pay taxes early in the process (for the conversions), to generate tax-free withdrawals later.
But SEPPs can help if you’re in an employer-sponsored plan or if you’re unable to implement a Roth IRA conversion ladder. Alternatively, you can use a SEPP with a Roth IRA conversion ladder or other income sources, at least until you reach 59½ .
Confused? You’re hardly alone.
What are Substantially Equal Periodic Payments?
SEPPs, or 72(t) distributions, don’t come up often in early retirement discussions, probably because they’re complicated. But in some situations, they may be one of the best strategies to minimize withdrawals from tax-sheltered plans, and that’s why they need to be on your early retirement planning radar screen.
SEPPs are available for both IRA accounts and employer sponsored retirement plans. That includes 401(k) and 403(b) plans, as well as traditional IRA accounts. However, there are different ways employer plans are handled compared to IRAs.
You must take SEPPs for at least five years, or until the day you turn 59½, whichever is longer. For example, if you begin taking payments at 50, you’ll have to continue taking them until at least age 59½. If you begin taking distributions at age 56, you’ll have to take them until at least age 61–five years.
While that’s taking place, there can be no plan contributions, conversions, rollovers, or non-SEPP withdrawals from the plan in question. Put another way, your retirement plan must be inactive except for SEPP distributions, and ordinary plan investment activity.
Separation from service exception. You can begin a SEPP at any age you choose. But there is a special provision in the law that allows you to begin taking distributions penalty free if you are separated from employment for any reason during or after the year you reach age 55. (The age is 50 for public safety employees of the federal government, a state, or a political subdivision of a state, and participate in a governmental defined benefit plan). The separation from service exemption is for employer-sponsored plans only, and does not apply to IRA accounts.
How Substantially Equal Periodic Payments Can Help Your Early Retirement
Once again, the basic problems with having most of your money in tax-sheltered retirement plans is the tax burden involved in making withdrawals prior to turning age 59½. At the same time, you may be completely dependent on those withdrawals since you won’t be eligible for Social Security for several years. Like a Roth conversion ladder, this is where a SEPP can help your cause.
It’s important to restate the point that SEPPs don’t eliminate ordinary income tax on your distributions. But they do take out the 10% early withdrawal penalty, and that’s more important than it seems at first glance. If you’re in early retirement, your income is probably on the low side, and you’re in a low tax bracket. Paying only say, 12% in ordinary income tax on retirement plan distributions probably won’t be the early retirement deal-killer you might be imagining.
Setting up a SEPP basically involves creating a distribution method–we’ll take a look at specifically how to do that in the next section. We’ll be using examples of annual distribution amounts, but you can also divide those into regular monthly payments.
But before we get into that…
An Unexpected Benefit: Keeping a lid on Required Minimum Distributions (RMDs) at 70½
An advantage of the SEPP is that you have access to your retirement savings earlier than you normally would. That is, the benefit of having your retirement savings would be spread out to cover more years. That can be a big advantage when it comes to RMDs.
The IRS requires RMDs beginning at age 70½. Since they’re based on life expectancy, you’ll have to begin withdrawing something like 4% per year from all your plans (the exception is a Roth IRA).
Now if you’ve accumulated $2 million in retirement savings at that age, 4% will see you taking $80,000 per year. That may be more money than you want or need. It also holds the prospect that you’ll drain down funds you hoped to pass on to your heirs. But on a more practical level, it may also put you into a higher tax bracket. When added to Social Security and any pension income you might have, an additional $80,000 could put you into a much higher tax bracket.
What’s more, the percentage you’re required to withdraw will increase progressively each year, as your life expectancy gets shorter.
But if you’ve been using a SEPP to take distributions over a much longer period of time, you’ll have a smaller retirement portfolio by age 70½. That will make the RMDs smaller, and reduce the potential tax liability. After all, if you early retire, you won’t have Social Security and pension income inflating your income and tax liability.
How to Work a SEPP
SEPPs offer a choice of three different distribution methods:
- Required Minimum Distributions,
- Fixed Amortization, and
- Fixed Annuitization
Let’s look at each method individually (you can get more information from the IRS Q&A page but below is a summary):
Required minimum distributions (RMDs). This method bases your annual payment on your remaining life expectancy. For example, if you’re 55, and your life expectancy is 85, you’ll be required to take a distribution equal to 1/30th of your plan balance. The payment will therefore change each year with the annual payment being slightly higher each year based on a declining life expectancy at each age. Of course, since your plan will continue to earn investment income, and the distribution is based only on a percentage, it probably won’t be exhausted even once you turn 85. No problem, the distributions will continue based on your remaining life expectancy from age 85. If you choose this method, you’ll have to keep it for life.
Fixed amortization. Under this SEPP method, fixed payments will be distributed over a fixed term, for example 20 years. However, you do have the option to switch over to the RMD method after at least five years, but once you do you’ll be there for life.
Fixed annuitization. This is a combination of the other two. In effect, you set up an annuity of fixed payments based on your expected lifespan. This method also gives you the option to make a one-time switch to the RMD method, which again, you’ll have to keep for life.
Three Different Calculation Methods for the Three Different Distribution Methods
The IRS also has three different life expectancy tables you can choose for your distributions:
Uniform Lifetime Table. This will generally result in the lowest annual distribution amount.
Single Life Expectancy Table (see page 46 of link). The main benefit is it enables you to choose the highest SEPP payout rate, if that’s what you want.
Joint and Last Survivor Table (see page 47 of link). This method brings your spouse into the picture, mainly if there’s an age gap of more than 10 years between you. The greater the age gap, the lower the annual payment will be.
So far, we’ve been discussing life expectancy in connection with SEPPs. But as with anything related to the IRS, it’s never quite that simple.
The IRS also figures in interest rates under the Fixed Amortization and Fixed Annuitization methods. That rate is calculated as 120% of the federal midterm rate–which are US Treasury notes with terms of between four years and nine years. That roughly correlates to the average length of a SEPP distribution period. And of course, since Treasury yields change on a regular basis, the rate used will change as well.
You’ll have to choose an interest rate for the Fixed Amortization and Fixed Annuitization Distribution methods. But that rate is the maximum rate you can choose. You’re free to select a rate that’s lower. You can choose a rate based on either of the two months immediately preceding the month when distributions begin. That will give you at least some control over your distribution amount. The rate chosen will be in place for the life of the SEPP.
Using either SEPP method, you’ll have to combine remaining life expectancy with the interest rate.
SEPP Payment Examples
Let’s look at SEPP annual payments using all three methods. We’ll assume you’re 50 years old, have $400,000 in retirement savings, and a life expectancy of 34.2 years. We’ll assume a 5% annual rate of return on investment, which is not the same as 120% of the federal midterm rate (it’s not you–this is confusing!).
Using the RMD method, you simply divide $400,000 by 34.2 years. That gives you an annual distribution of $11,696. At age 51, your life expectancy falls to of 33.3. Your $400,000 adds $20,000 (5%) investment income, but it’s paid out $11,696 the previous year. Your remaining balance than is $408,304. Dividing that by 33.3 years, your annual payout at age 51 is $12,261. Because the annual distribution is rising each year, your account may deplete at the end of your life expectancy.
For the Fixed Annuity and Fixed Amortization distributions, you’ll have to add an interest rate factor. The annual distribution amount will be something very similar to a reverse mortgage calculation. With either distribution method, the annual distribution will remain fixed for the term.
If you begin taking distributions at age 50 from a $400,000 plan, you’ll have a life expectancy of 34.2 years. But you’ll also have to add the 120% of the federal midterm rate. If that’s 2.98%, your annual payout will be $18,649.
To get that number, you can use a mortgage calculator. You’ll have to enter a “loan amount” of $400,000, at 2.98%, for 34.2 years (not all mortgage calculators can accommodate the odd term, but try the one at Bankrate).
These are just rough examples. The specific payout amounts and percentages will vary based on the life expectancy table you use, the assumed interest rate, and when you actually begin taking distributions.
Doing a SEPP After Rolling an Employer Plan into a Traditional IRA
It’s usually easier to do a SEPP from a traditional IRA. This is because employer-sponsored plans usually have rules regarding distributions. Since a traditional IRA is completely self-directed, you have complete control over how you structure your SEPP.
More important, you can set up a SEPP based on a single dedicated IRA account. For example, let’s say you have $1 million sitting in a 401(k) plan, and you want to begin taking penalty-free distributions beginning at age 50.
You decide you need $40,000 per year to retire comfortably. You do a rollover of $400,000 from the 401(k) plan into a traditional IRA. That will provide you with the needed income level for 10 years. By then you’ll be 60 (rounding up from 59½), and you’ll be eligible for penalty-free withdrawals based on your age.
Meanwhile, the $600,000 remaining in your 401(k) plan can continue to accumulate investment earnings over the next 10 years. At that point, you can begin making penalty-free withdrawals from that plan.
In a perfect world scenario, the $600,000 remaining 401(k) will grow to $1 million by the time you turn 60. Using the safe withdrawal rate of 4% (explained in the next section), you’ll continue to receive distributions of $40,000 per year for the rest of your life ($1 million X 4%).
Using the SEPP to cover your early retirement years will not only enable you to create an income flow, but also to maintain it throughout your life.
The Potential Pitfalls of a SEPP
This is a good time to bring up a few caveats:
Choose the right distribution rate. You’ll need to choose a distribution rate that will ensure your plan continues to pay distributions throughout your life. It’s generally recommended that you use the safe withdrawal rate (SWR) to make withdrawals from retirement accounts. The SWR is just a theory, but it holds that if you withdraw no more than 4% of your portfolio each year, you’ll never outlive your money.
The theory part is that it assumes you will earn a combined average annual return on stocks and bonds of greater than 4%. That will make sure you have money for living expenses, but that your portfolio continues to grow to cover inflation.
Whatever distribution rate you come up with for your SEPP should be as close to 4% as possible. If it’s in the 6% to 7% range, you may find yourself running out of money later in life.
Don’t change distribution methods within five years. If you do, you’ll lose the exception to the 10% early withdrawal penalty. And it looks like the penalty will be retroactive to the beginning of the SEPP plan, plus interest.
Consult with a tax professional before moving forward. As you can see from some of the detail in this article, setting up a SEPP is a complicated process. We recommend you consult with both your plan administrator and a CPA before choosing any particular option. The (sometimes) lifetime nature of SEPP distribution options, as well as the tax consequences, have to be carefully considered before making a final choice. Hopefully, we’ve given you enough information here that you’ll at least be able to ask intelligent questions.
You Probably Don’t want to Rely on Your SEPP Alone for Early Retirement
It’s important to stress that a SEPP is just one method of generating income from tax-sheltered retirement assets in early retirement that’s at least exempt from the 10% early withdrawal penalty. It doesn’t have to be your only method, and probably shouldn’t be.
As discussed earlier, the Roth IRA conversion ladder will probably be a better method for most people. You will have to pay ordinary income tax on the retirement assets converted to a Roth IRA. But once you do, you’ll create a cash flow that’s not only penalty-free, but also tax-free before reaching age 59½.
It may also be desirable to live on taxable investments, at least until you turn 59½ and can access your retirement plans penalty-free. That will be easier to do if you retire at say 55, than it will be if you go out at 45. It can be tough to save up a large amount of money without the benefit of tax deferral.
However you work out the pre-59½ income situation, just make sure it will provide you with a definite cash flow for the many decades that early retirement creates.
If you’d like a more detailed discussion of SEPPs, feel free to download a copy of The Complete Guide to Substantially Equal Periodic Payments (SEPP).