SEPPs: How to Make Penalty-Free Retirement Withdrawals

A Substantially Equal Periodic Payment, or SEPP, is a distribution method sanctioned by the Internal Revenue Service that allows for withdrawals from qualified retirement plans before age 59½. Its primary function is to provide a stream of income to individuals who retire early or need to access their retirement savings ahead of the standard retirement age. By following a strict set of rules under Internal Revenue Code section 72(t), an individual can take these payments without incurring the usual 10% early withdrawal penalty.

Key Decisions and Account Preparation

Before initiating a SEPP, you must identify which of your retirement accounts are eligible. SEPPs can be established using funds from:

• Traditional IRAs
• SEP IRAs
• SIMPLE IRAs
• Employer-sponsored plans like 401(k)s or 403(b)s, but only after you have separated from service with the employer.

A common strategy is to segregate your retirement assets. This involves splitting a larger retirement account into two separate accounts before starting the payments. For instance, if you have a $1 million IRA but only need distributions calculated on a $300,000 balance, you would first move $300,000 into a new, separate IRA. This new account is then used exclusively to fund the SEPP distributions, which isolates the SEPP from your larger portfolio.

You must also select one of the three IRS-approved calculation methods. The Required Minimum Distribution (RMD) method results in a payment that is recalculated each year, meaning it will fluctuate. In contrast, the Fixed Amortization and Fixed Annuitization methods produce a constant payment amount for the plan’s duration. Your selection depends on whether you prefer a variable payment that adjusts with market performance or a fixed payment for predictable budgeting.

Calculating Your SEPP Amount

Required Minimum Distribution Method

The RMD method produces a payment amount that changes each year. To calculate it, you take the account balance from the end of the previous year and divide it by a life expectancy factor from an IRS-approved life expectancy table. The specific table used—the Single Life Table, the Uniform Lifetime Table, or the Joint and Last Survivor Table—depends on your beneficiary designation. For example, a 50-year-old with a $500,000 IRA balance and a Single Life Table factor of 36.2 would have a first-year distribution of $13,812. The following year, the calculation is repeated with the new account balance and the updated life expectancy factor.

Fixed Amortization Method

The Fixed Amortization method calculates a fixed annual payment designed to deplete the account balance over your life expectancy. This calculation uses your starting account balance, a life expectancy factor from an IRS table, and an interest rate. The interest rate used can be any rate that is not more than the greater of 5% or 120% of the federal mid-term rate for either of the two months before payments begin. This rate determines the fixed annual payment you will receive for the duration of the plan.

Fixed Annuitization Method

The Fixed Annuitization method also provides a fixed annual payment. The calculation involves dividing the account balance by an annuity factor, which is derived from a reasonable mortality table and a permissible interest rate. This rate cannot be more than the greater of 5% or 120% of the federal mid-term rate. The annuity factor represents the present value of an annuity of $1 per year for life, and it is used to determine the fixed payment amount you will receive each year.

Maintaining Compliance with SEPP Rules

Once SEPP distributions have begun, you must adhere to a strict set of rules to avoid penalties. Payments must continue for a period that is the longer of five full years or until you reach age 59½. For example, an individual who starts a SEPP at age 52 must continue the payments until they are 59½. Conversely, someone who begins at age 58 must continue payments until age 63, satisfying the five-year minimum.

Another requirement is the “no modification” rule. After you select a calculation method and begin receiving payments, you cannot alter the payment schedule. The only modification the IRS permits is a one-time switch from either the fixed amortization or fixed annuitization method to the RMD method. This switch can be made in any year without being considered a modification that would trigger penalties.

The account funding the SEPP must be completely isolated. You cannot make any additional contributions to this specific account, nor can you take any other withdrawals from it beyond the scheduled SEPP distribution. Any such transaction, including rolling over other funds into the account, would be deemed a modification of the plan.

Tax Reporting and Plan Modification Consequences

The payments you receive are considered ordinary income and are subject to federal and state income tax in the year they are withdrawn. Your account custodian will report the distribution to you and the IRS on Form 1099-R. The custodian should use distribution code ‘2’ in Box 7 of the form, which indicates an early distribution with a known exception, signaling to the IRS that the 10% penalty should not apply.

The consequences for failing to adhere to the SEPP rules are significant. If you modify the plan by taking an incorrect amount or stopping payments before the required duration is met, the IRS will impose a recapture tax. This penalty retroactively applies the 10% early withdrawal penalty to every distribution you have taken since the plan’s inception. The IRS will also charge interest on those back-penalties.

Should you break the SEPP rules, you are responsible for calculating and reporting the recapture tax. The penalty is calculated on IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” This form must be filed with your income tax return for the year in which the modification occurred.