How to Tap IRAs Early
One 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 As you can see, the section says that funds may be withdrawn penalty-free from an IRA or qualified retirement plan at any age prior to age 59 1/2.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.
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.
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?