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If You Must Tap Your IRA Early, Know SEPP Rules

Everything about the rules for individual retirement accounts (IRAs) is intended to give the same message—this money is for retirement, and you should leave it alone until you’ve left work and you need alternative sources of income. Investment earnings aren’t taxed until you take withdrawals during retirement, giving your savings a chance to compound over the long haul. And just in case you’re tempted to tap your IRA early, there’s normally a 10% penalty on money withdrawn before you reach age 59½. That’s in addition to normal income tax that you’ll have to pay on distributions from the account.

There is, however, one relatively straightforward way to avoid the 10% penalty if circumstances force you to use part of your savings early. If you take a series of “substantially equal periodic payments” (SEPPs), you can skip the 10% payment, though you’ll still owe income tax on those payments.

To qualify for this special tax law exception, you must make arrangements with your IRA custodian to make payments to you from the account for a period of at least five years or until you reach age 59½, whichever is longer. For example, if you’re now 50, the payments must continue for at least 9½ years. There are three payment methods the IRS allows you to use, though in each case the amount of your withdrawals will be based on your life expectancy (or on the joint life expectancy of you and a beneficiary you designate).

The first option is the required minimum distribution (RMD) method. In this case, your annual withdrawal is determined by dividing the account balance by the number from the applicable IRS life expectancy table for the year. So if you have an account balance of $1 million and your life expectancy, according to the table, is 30 years, your payment the first year will be $33,333.33. With this method, your payments will vary slightly from year to year, affected by your changing life expectancy and the value of the account.

The second possibility is known as the fixed amortization method. Here, your annual payment is determined by amortization of the account balance over a period of years using a life expectancy table and an assumed interest rate. The IRS permits you to choose from two different life expectancy tables and several interest rate assumptions. But once you’ve made those selections, your annual payments won’t vary from year to year.

With the third option, the fixed annuitization method, your annual payment is determined by dividing the account balance by an annuity factor derived from a mortality table with an assumed interest rate. Here, too, the amount of the annual distribution remains the same over the length of the distribution period.

Of these three, the RMD method is the easiest to use, and it generally provides the smallest payout of the three methods, thus helping preserve more of your IRA to use during retirement. But if your goal is to maximize current payments, one of the other two methods may be preferable.

Once you’ve begun to receive payments, they must continue during the entire distribution period if you are to avoid the 10% penalty. You’re also not normally allowed to switch payment methods along the way. However, you can change one time from either the fixed amortization method or the fixed annuitization method to the RMD method. Such a shift might make sense if you see the value of your account dwindling and you’d like to minimize the annual outflows. By switching to the RMD method, you may be able to reduce the annual payments, particularly if your account has been hit with substantial stock market losses.

Another way to gain flexibility is to divide your IRA into two or more smaller accounts before you begin to take the SEPPs. That way, you could limit your withdrawals to a single account, thus leaving the rest of your IRA savings untouched. But if you then found you needed more current income, you could begin payments from a second account. And you’re allowed to choose a different distribution method for each IRA.

Again, the best approach is simply to allow the money you’ve saved in your IRA to remain untouched so that it can grow for many years before you begin withdrawals during retirement. But if you do need income in the meantime, well-structured SEPPs could be part of the solution. We can work with you to decide whether to tap your retirement accounts early and help you do it in a way that follows the rules and makes sense in your situation.