The “SEPP” Exception to the IRA Premature Distribution Tax

In these challenging economic times, you may be considering taking a withdrawal from your traditional IRA. While you’re allowed to withdraw funds from your IRAs at any time, for any reason, the question is, should you?

Why you should think twice
Taxable distributions you receive from your IRA before age 59½ are generally referred to as premature distributions, or early withdrawals. To discourage early withdrawals, they’re subject to a 10% federal penalty tax (and possibly a state penalty tax) in addition to any federal and state income taxes. This 10% penalty tax is commonly referred to as the premature distribution tax.

However, not all distributions before age 59½ are subject to the federal penalty tax. For example, the penalty tax doesn’t apply if you have a qualifying disability, or if you use the money to pay certain medical, college, or first-time homebuyer expenses.

The SEPP exception to the penalty tax
But one of the most important (and often overlooked) exceptions, from a retirement income perspective, involves taking a series of “substantially equal periodic payments” (SEPPs) from your IRA. This exception from the federal penalty tax is important because it’s available to anyone, regardless of age, and the funds can be used for any purpose.

SEPPs are amounts that are calculated to exhaust the funds in your IRA over your lifetime (or life expectancy) or the joint lives (or joint life expectancy) of you and your beneficiary. To avoid the 10% penalty, you must calculate your lifetime payments using one of three IRS-approved distribution methods, and take at least one distribution annually.

Calculating your payment
If you have more than one IRA, you can take SEPPs from just one of your IRAs or you can aggregate two or more of your IRAs and calculate the SEPPs from the total balance. It’s up to you. But you can’t use only a portion of an IRA to calculate your SEPPs.

You can also use tax-free trustee-to-trustee transfers (or rollovers) to ensure that the IRA(s) that will be the source of your periodic payments contain the exact amount necessary to generate the payment amount you want based on the IRS formulas. This makes the SEPP exception a very important and flexible retirement income planning tool.

Modifying your payments
Even though your payments must be calculated as though they’ll be paid over your lifetime (or over you and your beneficiary’s lifetimes), you don’t actually have to take distributions for that long. You can change, or stop, your SEPPs after payments from your IRA have been made for at least five years, or after you reach age 59½, whichever is later.

But be careful–if you “modify” the payments before the required waiting period ends, the IRS will apply the 10% penalty tax (plus interest) to all taxable payments you received before age 59½ (unless the modification was due to your death or disability).

For example, assume Mary began taking SEPPs from her traditional IRA account three years ago, when she was 43 years old (using one of the three IRS-approved methods). Mary does not take a distribution this year. Because Mary’s payment stream has been modified before she turned 59½, the 10% penalty (plus interest) will now apply retroactively to the taxable portion of all her previous distributions.

The five-year period begins on the date of your first withdrawal, so you can’t make any changes before the fifth anniversary of that withdrawal. This is true even if you turn age 59½ in the meantime.

For example, assume John began taking SEPPs from his traditional IRA (using an IRS-approved method) on December 1, 2009, and that he also took payments on December 1 of 2010, 2011, and 2012. John turned 59½ on December 2, 2012. Even though John is over age 59½, he must take one more payment by December 1, 2013. Otherwise, he’ll be subject to the 10% penalty on the taxable portion of the distributions he took before he turned age 59½.

Caution: To ensure that your distributions will qualify for the SEPP exception to the premature distribution tax, be sure to get professional advice. The calculation of SEPPs can be complicated, and the tax penalties involved in the event of an error can be significant.

Also, if your state imposes a penalty tax on early withdrawals, be sure to determine whether any similar exemption from the state tax is available to you.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013

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