Traditional IRA withdrawals

Ed provides insight on SEP exceptions and 72(t) withdrawals – both can allow pre-age 59.5 withdrawals without penalties.

Edward A. Zurndorfer

Tax-advantaged retirement accounts such as traditional IRAs provide individuals with many valuable benefits. In exchange, traditional IRA owners have to “lock up” their money for the long-term. If a traditional IRA owner needs early (pre-age 59.5) access to their traditional IRA, then the Internal Revenue Service (IRS) may charge a 10 percent early withdrawal penalty in addition to the federal and state income taxes owed on the distribution.

There are some exceptions that allow a traditional IRA owner to make withdrawals from their traditional IRAs without being subject to a 10 percent early withdrawal penalty. One such exemption being used is called a “72(t) withdrawal plan”. Under this program named for Section 72(t)(2)(A)(iv) of the Internal Revenue Code, a traditional IRA owner younger than age 59.5 can request to take a series of equal periodic payments from their traditional IRA even if they are still working. They will pay federal (ad state) income taxes on their IRA withdrawals, but no 10 percent early withdrawal penalty.

It is important to mention that the 10 percent penalty tax does not apply to any part of a traditional IRA distribution that is not taxable. The part of a traditional IRA that is not taxable is the portion of the IRA that represents the IRA owner’s contributions that were made with after-taxed dollars. These contributions – called “nondeductible” contributions – were reported by the IRA owner in the year they were contributed on IRS Form 8606 (Nondeductible IRAs). Since these contributions were made with after-taxed dollars, these contributions when withdrawn will not be taxed and also will not be subject to the 10 percent IRA early withdrawal penalty.

Substantially Equal Periodic Payments

A traditional IRA withdrawal by an IRA owner younger than age 59.5 is not subject to the penalty tax if the withdrawal is one of a series of substantially equal periodic payments (SEPPs). This exception applies to traditional IRAs and to qualified plan distributions (including 401(k) plans, 403(b) plans and the Thrift Savings Plan (TSP)). This penalty-free withdrawal in the case of qualified retirement will occur only if the qualified retirement plan portion sent has separated from the company or from the federal government (with the TSP) who is sponsoring the qualified retirement plan or the TSP.

SEPP payments are computed based on the IRA owner’s life expectancy or the joint life expectancy of the IRA owner and his or her designated beneficiary. Payments must be made at least annually.

There are three safe-harbor methods for satisfying the SEPP exception to the 10 percent penalty. They are: (1) Required minimum distribution based on life expectancy; (2) Fixed amortization based on single or joint life expectancy; and (3) Fixed annuitization method. Note that in using the required minimum distribution method or the fixed amortization method one of three life expectancy tables found in IRS Publication 590-B (Distributions from Individual Retirement Arrangements). They are the: (1) Single Life Expectancy Table;             (2) Uniform Lifetime table; or (3) Joint Life and Last Survivor Expectancy Table, as will be presented in an example below. The table chosen will be one of the factors that will determine the amount of the penalty-free (but taxable) monthly payment that the traditional IRA owner will receive.

The following table summarized the three methods for computing SEPPs:

Methods for Computing SEPPs under Internal Revenue Code Section 72(t)

 Required Minimum Distribution (RMD)Fixed AmortizationFixed Annuitization
Factors applied to account balanceSame as computing RMDs, except taxpayer can choose Uniform Lifetime, Single Life Expectancy, or Joint Life and Last Survivor Expectancy Tables.Single or joint life expectancy. Current Interest rate is no more than the greater of:   (1) 5% or (2) 120% of mid-term Applicable Federal Rate (AFR).Annuity factor from mortality table in Notice 2022-6. Interest rate is no more than the greater of:   (1) 5% or (2) 120% of mid-term AFR.
Method change allowed?NoYes, one-time switch to RMD method.Yes, one-time switch to RMD method.
 1 The IRS has allowed payments to be recalculated each year using the taxpayer’s life expectancy and the interest rate in effect for that year. However, the calculation method must remain the same each year (IRS Letter Rulings 200432021, 200432023, 200432024, and 200532062).

The following example illustrates:

Example 1. Frank’s traditional IRA balance on December 31,2021 was $300,000. Frank is age 53. His wife Tricia, age 50, is his traditional IRA beneficiary. Frank needs some additional income and decides to begin taking distributions from his traditional IRA starting in 2022. He wants to avoid the early withdrawal penalty by using the 72(t) program SEPP exception. Using the RMD method to calculate the payment. His distribution in 2022 will be $300,000 divided by a life expectancy factor found in IRS Publication 590-B, summarized as follows:

  • 1. Single Life Expectancy based on Frank’s age of 53: 33.4
  • 2. Joint Life and Survivor Life Expectancy based on Frank’s age of 53 and Tricia’s age of 50: 40.9

Frank wants to initially (during 2022) to receive the highest possible monthly payment. He therefore chooses the smaller life expectancy factor of 33.4. During 2022 Frank is receiving: $300,000 divided by 33.4 = $8,982 ($8,982 divided by 12 or $748.50 monthly).

How Long Must SEPP Distributions Last?

Once they begin, monthly distributions made under the SEPP exception do not need to continue throughout the IRA owner’s entire life. Payments may be altered or stopped completely after the later of:               

  • (1) The date the individual turns age 59.5; or
  • (2) The close of the five-year period beginning on the date the first SEPP distribution was received. The following example illustrates:

Example 2. Paula retires at age 57. She needs additional income and elect to withdraw $15,000 from her traditional IRA penalty-free based on the 72(t) SEPP program (RMD method) calculated to distribute over her single life expectancy of 29.8 years. Her annual payments during the first year are therefore $15,000/29.8 equals $503.36 ($41.95 monthly). Assuming Paula does not die or become disabled, her RMD-calculated distributions must continue for at least until she is age 62. At that time, Paula will be able to stop the monthly payments, to decrease the monthly payments, or to increase the monthly payments with no penalty.

Payments that stop at the IRA owner’s death or disability are also exempt from the tax and penalty if the payments met the SEPP criteria while the IRA owner was living and not disabled.

Recapturing the Penalty Tax

If SEPPs are modified – increased or decreased in any way other initially chose – or do not continue until the later of: (1) Age 59.5 or (2) A minimum 5 years of payments (see above) (except due to the IRA owner’s death or disability), the 10 percent early distribution penalty tax is applied retroactively (“recaptured”) in the year the SEPPs are modified. In this case, the recaptured tax is the amount of federal income tax that would have been imposed on the current year distribution and all previous distributions as if the exception had never applied. The early distribution penalty tax of 10 percent is applied only to the SEPPs received before the traditional IRA owner became age 59.5, even if the recapture event occurs after that date. Interest is also charged from the tax year the distributions would have been subject to tax through the tax year the modification occurred.

A word of caution: The SEPP – however calculated – is the exact monthly payment that must be made under this exception. Changing the payment will trigger the recapture tax discussed above. Also, once SEPPs have started, the traditional IRA owner should be careful not to make any additional contributions, nontaxable transfers, or rollovers into that account. Doing so will be treated as a change in the payment, resulting in recapture.

With these rules in mind, a traditional IRA owner is advised to not handcuff his or her entire IRA to a 72(t) program SEPP especially if the traditional IRA owner does need the entire IRA in order to address their current income needs. The traditional IRA owner’s goal in utilizing the 72(t) program SEPP is to produce the largest possible payment from the smallest possible traditional IRA that he or she owns. A traditional IRA owner can split the IRA Into separate accounts – one account used for the 72(t) SEPP and the other account that will grow undisturbed to be used if necessary in the future.

As discussed and shown in the table above, the IRS has approved three methods of calculating the payments under the 72(t) SEPP program: (1) RMD; (2) Fixed amortization; and (3) Fixed annuitization. Both the amortization and annuitization methods use a “reasonable interest rate” based on the higher of 5 percent or 120 percent of the midterm applicable federal rate (APR) issued monthly by the IRS. This year in IRS Notice 2022-6 the IRS issued guidelines authorizing a rate of up to 5 percent.

Understanding the 72(t) SEPP program and choosing the right options can be a challenge. Any mistake can result in additional taxes and expensive IRS penalties. It is important that any individual interested or needing to make pre-age 59.5 withdrawals from their traditional IRA to first consult with a knowledgeable financial advisor before engaging in a 72(t) SEPP program. For those individuals younger than age 59.5 who are facing an immediate financial emergency and have exhausted their other options for getting cash, using a 72(t) SEPP program to access traditional IRA funds may be worth considering. But it is important for individuals to remember that a 72(t) SEPP program can potentially seriously affect an individual’s long-term retirement security by depriving the individual’s traditional IRA used in the SEPP program of future tax-deferred investment growth.

Please be aware that the early distribution penalty tax exception, substantially equal periodic payments, available via Section 72(t) of the Internal Revenue Code, is subject to very specific guidelines, and thus, various factors should be carefully considered. Investors should understand the account value (net equity and/or principal balance) could potentially be exhausted if the distributions exceed the earnings and growth of the investment(s) in the account. Also, the ability to sustain substantially equal payments can be compromised if the account is exposed to higher volatility through higher risk or growth-oriented products. Always consult the advice of an independent tax professional prior to initiating 72(t) substantially equal periodic payments.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Traditional IRA withdrawals

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