“It’s great if you want (or need) to retire before age 59½, just be aware of the potential tax consequences.”- Jerry Yu
If you have ever thought of retiring early, your advisor might have mentioned something called “substantially equal periodic payments,” or SEPP. These are also often referred to as 72(t) distributions.
Anyone who wants or needs to retire before reaching 59½ faces some fundamental tax challenges. Most people have accumulated the bulk of their savings through the use of tax-sheltered retirement plans. So, retiring early means they will not only pay ordinary income tax on their withdrawals, but they get hit with an additional 10% early withdrawal penalty.
SEPP is a means of drawing down funds from an IRA or other qualified plan before reaching age 59½ that gives people who want to retire early a chance to receive payments without the early withdrawal penalty. IRS formulas form the basis of withdrawal amounts.
SEPPs can help if you’re in an employer-sponsored plan or if you can’t implement what’s known as a “Roth IRA conversion ladder.” A SEPP generally works best for people who need steady streams of pre-retirement income. For example, those forced to end their careers earlier than planned.
SEPPs, also known as 72(t) distributions, are complicated as only the IRS can make things. However, they may be one of the best ways to minimize withdrawals from tax-favored plans for people in certain situations.
Except for your current employer’s 401k plan, you can use a SEPP with any qualified retirement account. SEPP arrangements may be initiated by either your financial advisor, or you can apply directly to a company specializing in these arrangements.
When you start your plan, you will need to choose one of three IRS-approved methods of distribution calculation. You may go with either required minimum distribution, annuitization, or amortization.
Each method has a different calculated annual distribution, so you and your advisor must determine what works best in your particular situation. You must take SEPPS for at least five years, or until you turn 59½, whichever is longer. For instance, if you decided to retire and start taking payments at age 57, you need to take them until age 62. During that period, your retirement plan is in a kind of hibernation. You cannot convert, contribute, or roll over anything from your SEPP plan except SEPP distributions.
As I said before, the main issue with having the bulk of your cash in tax-sheltered plans is the tax burden and penalties you incur if you need to take your money out early. Unfortunately, suppose you have been laid off or otherwise have to retire before you anticipated. In that case, your plan withdrawals may be your only source of cash until you qualify for Social Security.
Summing it up: For some people who either want or need to retire early, SEPPS can be a valuable way to soften some of the tax blows you’d typically get when withdrawing plan money early. Having a SEPP in place, while it does not relieve you of your tax obligations, does provide you a chance to avoid the 10% early withdrawal penalty should you retire before age 59½.
However, SEPPS are complicated and must be appropriately planned with the assistance of a retirement and income expert. It would be best to understand the dozens of rules, exceptions, and scenarios before putting a SEPP in place. Consult your CPA or financial advisor to discover all the implications of using a SEPP for early retirement.
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