Penalty-Free Early Withdrawals From a Retirement Plan

As the Great Recession rumbles on and on for just about everyone except those in the top 10% of income brackets, people are increasingly tapping into their IRAs. If you're not 59 and 1/2 or older, you'll pay a penalty of 10% of the amount withdrawn, on top of applicable federal and state income taxes. There is a way, however, to dodge the penalty: substantially equal periodic payments plans (SEPPs). These plans let you withdraw IRA funds without penalty, although regular federal and state income taxes will still have to be paid. SEPP plans can be complex, and you may want the assistance of a tax accountant or financial planner if you're going to use one. Here's a general picture of how they work.

A SEPP plan runs for a minimum of five years or until you reach age 59 and 1/2, whichever is longer. If you start a SEPP plan at age 57, you have to stick with it until you reach age 62. If you're younger than 54 and 1/2, the plan has to continue until you reach 59 and 1/2. So, if you start a SEPP plan at age 45, you'll have to stick with it for 14 and 1/2 years. If you don't stick with the plan and complete it, the IRS will assess a 10% penalty on everything you withdrew before the time you dropped the plan. Since you presumably instituted the SEPP because you were short of cash, that penalty could be painful.

During the time the plan is in effect, you get payments each year (which can be monthly, if the plan is set up that way). The distributions are calculated one of three ways: the amortization method, the annuitization method, and the required minimum distribution method. The first two are somewhat like what you would get from a commercial annuity purchased with the amount of money in the SEPP plan (although this is just an approximate description). You have a fixed amount that is paid out each year, and that amount never changes over the life of the plan. But, unlike a commercial annuity, this payment is not guaranteed and if the investment performance of your IRA lags, you could drain off the balance faster than you expected. (In fact, you can run out of funds before the plan is over; but the IRS won't penalize you for inability to complete the plan because of investment losses.)

The third method, required minimum distribution, is like the formula used for regular required minimum distributions from IRAs (i.e., those for people 70 and 1/2 or older). You take the SEPP account balance and divide it by the owner's life expectancy as estimated by the IRS. The resulting number is paid out. But the distribution has to be recalculated each year (using the owner's ever shortening life expectancy). So the required minimum distribution method is likely to pay out different amounts each year. It also tends to result in smaller payments than the first two methods. But the nature of the required minimum distribution formula means that you'll never run out of the money. You just won't know for sure how much you'll get every year--potentially more after a year of investment gains, and possibly less after a year of investment losses.

If you start with either the annuitization or amortization method, you can make a one-time switch to the required distribution method. This would be advisable if the original method is depleting your account balance faster than you feel comfortable with. Thus, you can reduce the impact that investment losses have on your account balance, but you'll get much lower periodic payments.

You can use some or all of the funds in an IRA for a SEPP plan. If you're going to use less than all the funds, transfer part of your IRA into a separate IRA that is used for the SEPPs. If your retirement money is in an employer sponsored retirement plan like a 401(k) or a 403(b), you cannot do a SEPP plan--it's allowed only for individually owned retirement plans. But if you're no longer employed at that employer, you can transfer the funds to an IRA and do a SEPP plan from the IRA.

A SEPP plan isn't useful for making one-time withdrawals, such as getting a downpayment for a car or house. It's a long term proposition, with a measured payout for each year of the plan. If you need a short term boost in cash flow, look elsewhere, or make the one-time withdrawal and pay the 10% penalty along with income taxes.

The amount you can take out at any one time through a SEPP plan is limited to whatever you can get per year under one of the three permitted methods of withdrawal. You can't use a SEPP plan to take out half the balance of your retirement account at once, or some other ad hoc amount that suits your needs at the moment.

Don't do a SEPP plan unless it's really necessary. You'd be burning up retirement resources earlier in life, which means your golden years may be less golden. Of course, sometimes life isn't kind and you need access to the money in your retirement account. The fact that a SEPP plan avoids the 10% penalty may be significant if you have to make long term withdrawals. For more information, you can visit the IRS website at http://www.irs.gov/retirement/article/0,,id=103045,00.html.