There is a common misconception among Americans that you cannot retire before age 59.5, and it is simply not true. The belief does rest on some actual facts. Congress, in its wisdom, set 59.5 as the age at which you may withdraw from your retirement accounts and IRA’s without incurring an ‘additional tax’ of 10%. However, many fail to dig deeper to discover that there are many exceptions to the rule, allowing those who have saved enough to begin retirement well before the arbitrary age of 59.5. In this article, we’ll delve into one of the more common exceptions for retirees: the Substantially Equal Payment Plan or SEPP.
There is, of course, a great deal of fine print when creating a SEPP, but the basics are fairly straightforward: a SEPP allows retirees to withdraw a series of equal payments over a period of no less than 5 years. As long as the SEPP is followed carefully no 10% additional tax will be assessed on the distributions, allowing access to those retirement accounts well before the 59.5 hurdle. (Note that I say ‘additional tax’ can be avoided; there will still be the regular tax on the distributions.) The SEPP is sometimes called a ‘72t’ because Internal Revenue Code Section 72(t) is where the exception is found. 1
Creating a SEPP does require very specific calculations and the rules must be followed precisely, so I highly recommend that you enlist the help of an expert. For example, there are three ‘safe harbor’ methods for calculating the amount you may take out each year. The calculations are intended to make sure that your money will last for your lifetime and thus they keep the distribution amounts fairly low. Also, when the IRS says that you must take equal payments each year for a minimum of 5 years they do mean ‘equal’. Taking an additional amount or skipping a distribution could break the plan and result in retroactive and cumulative imposition of the 10% additional tax plus penalties and interest – not something to take lightly!
Many are fearful of locking themselves up into a plan that requires the same draw every year. After all, life is uncertain. What if you have an unexpected expense or get the job offer of a lifetime? You may want to take a little more or a little less. Fortunately, there are ways to navigate these uncertainties. One great tip is to exclude some of your IRA money from the SEPP; you don’t have to lock up all of your money. Have an account on the side that you can draw upon in case of emergency. If, on the other hand, you no longer need the money, there is actually a way to reduce your distributions without breaking your SEPP. Essentially the law provides for a one time change in your calculation method. These rules are complex so be careful and enlist the help of an expert!
When I have a client that wants to retire before age 59.5, I like to develop a pre-59.5 plan to find the exceptions that work best for that specific situation. By using the right tools at the right time we can usually craft a plan that provides for sufficient income, provides at least some flexibility, and still avoids the 10% additional tax. The SEPP, while complex, is an important tool that can save thousands of dollars in taxes and free those who have saved well to retire before the 59.5 hurdle.
1 Specifically, IRC 72(t)(2)(A)(iv) provides an exception that allows you to withdraw funds as “part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary.”