Early Retirement Distributions—SEPP - 2021 | Best Guide - CPA Clinics
You may choose, or be forced into choosing, early retirement. Retirement before age 59½ may create income challenges. You are not yet eligible to receive retirement benefits from Social Security. You may or may not have a monthly pension to generate income.
In many situations, you will need to generate income from your assets. Often, most of your assets are in a retirement plan through a 401(k) plan at your employer or in an individual retirement arrangement (IRA). Withdrawals of earnings and pre-tax contributions are subject to ordinary income tax. In addition, you may be subject to the 10% early withdrawal penalty tax on distributions taken before you reach age 59½.
One strategy to generate income from retirement accounts if you are under age 59½ is to take periodic distributions from those accounts. If structured properly, the 10% additional tax will not be assessed on the distributions. You can take distributions from various retirement accounts such as 401(k) plans, 403(b) plans, and IRAs.
The Internal Revenue Code allows you to take withdrawals from retirement accounts without incurring the 10% penalty. To do so, very specific rules need to be followed.
Example: Fred, age 52, establishes a SEPP from his IRA. He must continue to take withdrawals until he reaches age 59½. If he discontinues or changes his SEPP withdrawals at any time before he reaches age 59½, unless an exception applies, the current year withdrawal is subject to the additional 10% tax. In addition, the SEPP withdrawals for previous years are retroactively subject to the additional 10% tax.
If, however, Fred begins SEPP withdrawals at age 58, he must continue the withdrawals to age 63 to comply with the 5-year withdrawal requirement.
Payments are considered to be substantially equal periodic payments if they are made in accordance with one of the three calculation methods allowed.
If you begin distributions in a year using either the amortization method or the annuitization method, you may in any subsequent year switch to the required minimum distribution method to determine the payment for the year of the switch and all subsequent years. The change in method will not be treated as a modification. Once a change is made, the required minimum distribution method must be followed in all subsequent years until the required number of years under the plan have been met.
No other contributions or distributions can be taken from the account being distributed from during the SEPP period. This includes nontaxable transfers in or out of the account.
Example: Susan establishes a SEPP distribution from her IRA. Two years later, at age 53, she takes on a new job and wants to make contributions to an IRA with her newly earned income. Susan cannot contribute to the IRA that is making her SEPP distribution. Susan can establish a new, separate IRA account that she can make contributions to.
If, as a result of following an accepted method of determining SEPP withdrawals, your IRA assets are exhausted, you will not be subject to the additional income tax of 10%. The resulting cessation of payments will not be treated as a modification of the series of payments.
Example: Dick established a SEPP distribution plan at age 54 that required him to take a distribution amount of $25,000 each year. He invested aggressively in his SEPP account and, due to distributions and declines in the stock market, the value of his account was down to $15,000 when Dick took his distribution at age 58. Because the account has been depleted, none of the amounts distributed through the SEPP plan in prior years are subject to the 10% additional tax. In addition, the $15,000 distribution at age 58 is not subject to 10% additional tax. Also, because the account has been depleted, he will face no tax consequences for not being able to take a distribution at age 59.
