The IRS recently made changes to the amount of money that can be withdrawn each year from retirement accounts before age 59 1/2. As with the increase in overall inflation, the reasonable interest rate permitted by the IRS for determining certain types of these distributions recently increased to 5% or 120% of the mid-term rate (currently 1.40%), whichever is greater. This effectively makes the amount of money each taxpayer can withdraw without penalty each year higher than before. These withdrawals are called substantially equal periodic payments.
Substantially equal periodic payments allow you to take early distributions from your qualified retirement accounts without penalty, but with certain provisions. According to the IRS rules, you can avoid the 10% penalty rule on early distributions before 59 ½ with a SEPP plan in which money is distributed for a period of five years or until the you turn 59 ½ — whichever comes later. This means that once you decide to take distributions with this plan, you will have to continue drawing on the money until you fulfill one of the plan age requirements to avoid major penalties.
There are three different ways to withdraw money and stay within the SEPP rules.
- Required Minimum Distribution: this method allows for an annual payment that is determined each year by taking the account balance and calculating the life expectancy of the taxpayer. Sometimes this is done by simply dividing the account balance by the life expectancy. Since the account balance changes every year, the payment amount must be recalculated annually. This method typically results in lower withdrawal amounts than the other two methods.
- Amortization: Under this method, the annual payment is the same for each year of the program. The amount is determined using the life expectancy and a predetermined interest rate. Under the new IRS rule, the interest rate has been increased to 5%.
- Annuitization: As with the amortization method, the amount of money in your distribution each year is the same with the annuitization method. This method is calculated by using the taxpayer’s age and pre-determined interest rate — up to 5% under the new rule. According to the IRS, the annual payment for each distribution year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the employee’s current age and continuing for the life of the employee. This annuity factor is found using the mortality rates as determined by the IRS.
For all methods in general, the important part to remember is that you will have to stick to whatever method you have chosen — which could backfire on you if you decide to take it too soon. For example, suppose you choose an amortization SEPP payment method starting at age 50. This means you will have to take distributions for almost an entire decade, even if you decide you took money too soon. Once you reach 59 ½, you will have emptied one of your accounts for almost ten years and will still be almost three years before the minimum claiming age for Social Security.
The downside to this can be that you draw on your retirement accounts too much too soon and not have enough left over when your actual retirement begins. SEPP plans are potentially risky strategies that need to be approached with caution, as they can lead to a fast depletion of retirement funds, leaving a taxpayer ill-prepared for their important later years of life.
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