Introduction                                                                                                                                       

Often, we find clients are looking to retire and start living off their 401(k) and/or ESOP prior to turning age 59½ and would like to avoid the pre-mature distribution penalty of 10% that is assessed on early distributions from both IRAs and 401(k)s, as well as other qualified retirement plans.

As an investor, it’s important to understand the various exceptions to the IRS 10% additional tax for early or pre-59 ½ taxable distributions from Individual Retirement Accounts (IRA) and/or Qualified Employer Sponsored Retirement Plans (QRPs) – such as 401(k) and 403(b) plans. However, there are exceptions to the 10% additional tax. In this white paper, we will explore three such exceptions: “Substantially Equal Periodic Payments (SEPP) sometimes called 72(t) payments,” the “rule of 55,” and “qualified education expenses.” 

Rule 72(t)

Distributions taken as a Substantially Equal Periodic Payments (SEPP), under Section 72(t), allows for an individual to take distributions from an IRA or QRP before they reach age 59½ without incurring the 10% additional tax.2 There are four conditions for the distribution to meet the SEPP exception and there are three methods for calculating these payments.3

To qualify for the SEPP exception, the following four conditions must be met:

1. The distributions taken must be substantially equal and periodic.
2. These payments must be based on your life expectancy or on the joint life expectancy of you and your beneficiary.
3. You must continue to receive these payments for at least five years or until you reach age 59½, whichever is longer. The five-year period ends on the fifth anniversary of the first distribution. For example, if you began SEPP distributions at age 56 on December 1, 2022, you may not take a different distribution or alter the amount of the payment until December 1, 2027, the fifth anniversary of the first distribution, even though your fifth payment will be taken on December 1, 2026.
4. Distributions must be calculated using an interest rate that is no more than 120% of the federal mid-term rate for either of the two months immediately preceding the month in which the distribution begins, or 5% distributions taken must be substantially equal and periodic.

There are three IRS accepted methods of calculating the sub-stantially equal periodic payments. They include:

• Amortization method. This is similar to the method of calculating mortgage payments. The account balance is amortized over your life expectancy (or over the joint life expectancy of you and your designated beneficiary). IRS mortality tables and a rate of interest not to exceed 120% of the federal mid-term rate, or 5% are used for the calculation.
• Annuity factor method. The payment is calculated by dividing the account balance by an annuity factor. The annuity factor is derived using up to 120% of the federal mid-term rate, or 5%, your attained age, and a divisor from the annuity table found in § 1.401(a)(9)-9(e). Using either of these two fixed methods (amortization and annuity), the distributions will be consistent over the SEPP distribution time frame
• Required Minimum Distribution (RMD) method. Annual payments are calculated similarly to those that are required when an IRA owner reaches RMD age. However, this is just a calculation method and unlike RMDs, you cannot take more (or less) than the calculated amount. The most recent year-end account balance is divided by a life expectancy based on one of the IRS life expectancy tables. Once a table is chosen, that same table must be used for all subsequent years. This method tends to give you the lowest payment, and those payments must be recalculated annually using the most recent year-end account balance as well as a revised life expectancy divisor. You may find this to be the least favorable calculation method if you are trying to maximize your income from SEPP distributions. This method would require a larger IRA balance to get the same targeted income than would be available using one of the fixed calculation methods.

Modifying your SEPP before the 5-year or age 59½ time frame can result in retroactively owing the 10% additional tax and interest on all taxable amounts that were distributed. If a modification does occur, you must wait until the next tax year to begin a new SEPP distribution from the IRA that had the SEPP modification.

Modifications that might trigger such additional tax may include:

• Terminating the SEPP
• Taking a distribution that is more than or less than the calculated payments from the IRA or IRAs supporting the SEPP
• Additions, contributions, or transfers into the IRA(s) dedicated to the SEPP distribution
• Rolling over a SEPP amount

Sarver Vrooman Wealth Advisors uses a SEPP 72(t) calculator to provide the three options for clients under 59½ who are looking to take distributions from their IRA prior to age 59 ½.

Rule of 55

The rule of 55 allows you to take distributions from your QRP prior to age 59 ½, without incurring the 10% additional tax provided you separate from service in the year in which you turn age 55 or older. This exception applies only to the employer-sponsored plan you were participating in at the time of separation from service. If you roll over the funds to an

IRA, the rule of 55 no longer applies, and you will be subject to the 10% additional tax unless another exception applies.

Qualified Higher Education Expenses

Qualified higher education expenses avoid the 10% additional tax. Expense include: tuition, fees, books, supplies, and equip-ment. Room and board are also qualified expenses for students who are enrolled at least half-time.

Expenses can be used for the IRA owner, their spouse, child, or grandchild at an eligible educational institution offering post-secondary education

This exception only applies to distributions from IRAs.

Conclusion

In conclusion, there are several exceptions to the IRS 10% additional tax for IRA and QRP distributions. Some of these only apply to the IRA and some only apply to the QRP so it is important to understand the rules. Often, we will recommend that clients combine a “hybrid strategy,” based upon their needs, and employ two (2) or more of the three (3) exceptions above to have greater flexibility and optimally take advantage of the exceptions to the 10% additional tax for IRAs and QRPs. However, not all exceptions can be combined. It’s important to understand these exceptions and consult with a financial advisor ads well as your tax and legal advisors before making any early distributions from your IRA and/or QRP.

Although you can begin 72(t) SEPP distributions at any age, individuals younger than age 50 must maintain longer time commitments. This often increases the risk that you would need to alter your series of payments before age 59½ due to changing income needs, which could result in retroactive tax and interest charges. Once begun, the substantially equal periodic payments must continue for five years or until age 59½ whichever is longer. If there is any modification to the 72(t) SEPP schedule prior to the completion of this time frame, a 10% additional tax will be applied to all distributions, retroac-tively and with interest. If you are near age 59½, you may want to consider tapping taxable assets first to bridge any income gap until your IRA is no longer subject to the 10% additional tax at age 59½. You should also review the distribu-tion rate necessary to meet your income needs. Distribution rates that exceed investment rates of return may jeopardize your ability to sustain distributions through retirement.