How to Tap IRAs Early

Aug 27, 2013 by

early retireesOne piece of housekeeping before we dive into understanding how you can get money from your IRA penalty-free before age 59-1/2: Just because you can make early, penalty-free IRA withdrawals doesn’t mean you should make early IRA withdrawals. You might have the good fortune to live until age 100, and you’ll need money for the whole trip! You’ll likely have ‘aged out’ of being even a Wal-Mart greeter long before then!

Substantially Equal Periodic Payments

Bureaucracy spawned terminology is easier to spot than Donald Trump at a bald guys’ convention, and the IRS may be the best at naming stuff. Its writers have gifted us with

Substantially Equal Periodic Payments

which starting now I will refer to as SEPP. If you want to withdraw money before age 59-1/2 but don’t want to pay the 10% early withdrawal tax penalty, you need to learn about SEPP.

Basis of Substantially Equal Periodic Payments ‘Loophole’

Please open your copy of the Internal Revenue Code to Section 72(t)(2)(iv). Got it? Okay, good. As you can see, the section says that funds may be withdrawn penalty-free from an IRA or qualified retirement plan at any age prior to age 59 1/2. But doing so according to some simple rules would be contrary to the entire philosophy underlying the U.S. tax code, so you’ve got to muddle through the three options the IRS gives you for making SEPPs.

Three Ways to Withdraw Substantially Equal Periodic Payments From Your IRA

Here are the SEPP calculation methods. To complicate things just a bit more, each will yield a different withdrawal amount.

Life Expectancy Method
Now retrieve from your files your copy of IRS Publication 590-B, Distributions from Individual Retirement Arrangements. Therein, and without requiring a physical exam or even a photo of you in the buff, the IRS will tell you how long it expects you to live. If that’s 25 years and you have $250,000 in your IRA, then in year 1 of your SEPP withdrawal period you may withdraw $10,000.

→ $10,000 = $250,000 ÷ 25 years

For year two, you’ve got two choices to figure your withdrawal:

Choice 1: Year 2 withdrawal = Current IRA Account Balance ÷ 24 years (that’s 25 years minus 1 year passed)

Choice 2: Year 2 withdrawal = Current IRA Account Balance ÷ New life expectancy

See, since you’ve made it through another year, the chances are now greater that you’ll live more than 25 years that the IRS expected you to live last year. So in Choice #2 you have to use the IRS’ new life expectancy for you, now that you avoided the grim reaper for a year. Got it?

Whichever calculation choice you make, you have to stick with it. No fair bouncing back and forth to the one that results in the larger withdrawal.

The Life Expectancy Method yields the smallest annual withdrawal of the three options, so maybe you don’t want to spend a lot of time trying to understand the mathematics and logic above.

Amortization Method
Unless you’re a lot smarter than me (and trust me, most of you are), you’ll likely need a tax advisor’s help with this one.

Again, you start with your life expectancy, per the IRS. Then you assume a reasonable earning rate for your IRA investments that, when combined with your selected annual withdrawal amount, will result in consumption of your entire IRA account over your IRS-predicted life expectancy. Choose an indefensibly high (in the IRS’ view) earnings rate and your plan’s not going to fly with the tax people.

Annuity Method
This method is similar to the Amortization Method except that standard insurance industry life expectancy tables are used instead of the IRS’ tables. Of the three options, the Annuity Method generally results in the highest annual withdrawal. I think that means that the IRS is more optimistic about your life expectancy than are life insurers.

Substantially Equal Periodic Payments Warnings and Caveats

There’s more to think about before you embark on the SEPP path:

  • Once you start SEPP, you must continue for at least five years or until you’re age 59-1/2, whichever occurs later.
  • Screw up the math or stop withdrawals too early or change your calculation method and you’ll be zapped with the 10% penalty for the money you’ve already withdrawn.
  • Because of the importance of getting the math right and choosing an earnings rate that the IRS won’t challenge, hiring a tax advisor and documenting everything is recommended.

What Do You Think of Substantially Equal Period Payments?

Are you taking SEPP? Or can you foresee circumstances where SEPP might make sense for you? What would be your reservations about taking SEPP?

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  • Joe

    We’ll probably avoid the 72t unless we have way too much money in the IRA. It’s probably better to take out some out earlier rather than being forced to take RMD later. We’ll see what the tax situation is like in 20 years. 🙂

    • Yes, those pesky taxes must be a factor in all stages of life’s financial planning. Maybe when Baby RB40 is president he’ll simplify things. 🙂

  • Interesting. I didn’t know about this option. However I am building a taxable account to overcome early withdrawals. Is SEPP the same for ROTHs as well?

    • SEPP does apply to a Roth IRA as well. However, remember that Roth IRA contributions can be withdrawn tax-free at any time, so SEPP becomes irrelevant with respect to Roth contributions. The benefits of SEPP would apply if the Roth IRA account holder wanted to withdraw money beyond his or her contributions, which I’m thinking would be quite rare. Be careful though if you withdraw money from a Roth that got there through a conversion from a Traditional IRA fewer than five years ago. You may get zapped by the IRS.

      • oh, yes, that’s true. I forgot about that the ROTH isn’t that strict. Well, thanks for clarification. One more question. Can you roll 401k into ROTH? And what implications it would have?

        • You’re stretching my knowledge Martin, so best to get an investment pro’s advice on this. I do know that the American Taxpayer Relief Act of 2012 made allowable in-plan conversions. So you can convert your 401k money to a Roth 401k within the same employer plan. However, the legislation only makes such a conversion legal; it doesn’t require your employer to modify its plan documents to allow the in-plan conversion to a Roth 401k. So you’d have to talk to your plan administrator to learn what’s allowed and lobby for the conversion provision if you want it.

          And you can certainly roll your 401k directly into a traditional IRA, as you know. Then the traditional IRA could be converted to a Roth, with the requisite payment of taxes on the converted amount. To my knowledge, you can’t roll a 401k directly into a Roth IRA in a single step. Maybe another reader with greater expertise will help educate us.

          • Kurt no worries, I was just curious in case you quit your job and take your 401k with you and instead of rolling into a new 401k I would prefer maybe rolling it into ROTH (either via IRA and then ROTH) and start a new 401k with the new employer (and not sure if this is possible whatsoever) I do not have that experience or knowledge. It was just a thought.

  • Thanks for the details about IRA withdrawals and SERP. I was not aware about the withdrawals from IRA. For now, we have no idea of withdrawing but maybe if need comes we may think of this SERP in future

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