What are early distributions from a retirement account?

An early or “premature” retirement distribution is a withdrawal of funds from your retirement account before the designated age at which there are no penalties on withdrawal (59 ½ in the case of an IRA). In most cases, you must pay taxes on early retirement distributions. Additionally, the rules for how and when you may make an early withdrawal can vary.

What happens if I cash out my retirement early?

In many situations, you will need to generate income from your assets. Often, most of your assets are in a retirement plan through a 401(k) plan at your employer or in an individual retirement arrangement (IRA). Withdrawals of earnings and pre-tax contributions are subject to ordinary income tax. In addition, you may be subject to the 10% early withdrawal penalty tax on distributions taken before you reach age 59 ½.

How can I make my retirement withdrawals more tax-efficient?

One strategy to generate income from retirement accounts if you are under 59 ½ years old is to take periodic distributions from those accounts. If you structure your distributions properly, you can avoid the 10% additional tax on your withdrawals. You can take distributions from various retirement accounts such as 401(k) plans, 403(b) plans, and IRAs.

A Substantially Equal Periodic Payment (SEPP) plan is a little-known program that allows you to take withdrawals from retirement accounts without incurring the 10% penalty through specified annual distributions over a period of five years or until you turn 59 ½, whichever comes later. However, one caveat is that you will still owe income tax on the withdrawals.

Who qualifies for SEPP?

You can set up a SEPP plan with any qualified retirement account except a 401(k) you hold at your current employer. However, there are some very specific rules you’ll need to follow:

  • The payments made to you from the IRA must rely on one of three calculation methods. 
  • The payments must be made to you annually during the payment years. Payments can be made more frequently, such as monthly, but the total for each year during the SEPP period must meet the payment calculation result for the year or years during the SEPP. 
  • Payments must be made for a period of at least five years or until you reach age 59½, whichever is later. 

For example, if you establish a SEPP from your IRA at age 52, you must continue to take withdrawals until you reach 59 ½. If you discontinue or change your SEPP withdrawals before you reach that age, the current year withdrawal is subject to the additional 10% tax unless an exception applies. In addition, the SEPP withdrawals for previous years are retroactively subject to the 10% tax. 

If, however, you begin SEPP withdrawals at age 58, you must continue the withdrawals to age 63 to comply with the 5-year withdrawal requirement. 

To be “substantially equal periodic payments,” your payments need to meet the standards of one of the three calculation methods allowed: 

  1. Required minimum distribution method. Under this method, the account balance, the number from the life expectancy table, and the resulting annual payment amount is re-determined each year. 
  2. Fixed amortization method. The annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years determined using a life expectancy table and a chosen interest rate. Under this method, the annual payment is determined once for the first distribution year, and the annual payment is the same in each succeeding year. 
  3. Fixed annuitization method. The annual payment for each 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 taxpayer’s age and continuing for the taxpayer’s life. The annuity factor is derived from a mortality table and a chosen interest rate. Under this method, the annual payment is determined once for the first distribution year, and the annual payment is the same amount in each succeeding year.

If you begin distributions in a year using either the amortization method or the annuitization method, you may in any subsequent year switch to the required minimum distribution method to determine the payment for the year of the switch and all subsequent years. The change in method will not be treated as a modification. 

Once you make the change, you must follow the required minimum distribution method in all subsequent years until you meet the required number of years under the plan. You may not take any other contributions or distributions from the account from which you are taking distributions during the SEPP period.

If, as a result of following an accepted method of determining SEPP withdrawals, your IRA assets are exhausted, you will not be subject to the additional income tax of 10%. The resulting cessation of payments will not be treated as a modification of the series of payments. 

What are the drawbacks to a SEPP plan?

A SEPP plan can be a beneficial tool for those who need to access retirement funds early. However, there are also some direct drawbacks to this approach.

For example, the rules for distributions using the Internal Revenue Code provide very little flexibility. Once the distribution begins, you must exert extreme caution in making any changes to the distribution amount and frequency.

Furthermore, it would help if you documented the calculations used to determine the distribution and any change in distribution. Tax courts have consistently assessed the 10% additional tax for taxpayers who could not substantiate the distributions were, in fact, based on SEPP calculations.

In conclusion

If you plan to retire early, it’s essential to consider the tax consequences associated with taking an early retirement distribution. It is always a good idea to consult with a tax professional to make the process as tax-efficient as possible.

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