Substantially Equal Periodic Payments

Under IRS Code Section 72(t), a person can withdraw money from their tax-deferred retirement accounts such as 401(k) plans, 403(b) plans, and individual retirement arrangements (IRAs) without paying a penalty, provided they follow certain guidelines. However, this strategy has its drawbacks, especially if it is used for long-term cash needs. It will also prevent the account from earning additional income, which can be detrimental to your financial security later in retirement. Rule 72(t) allows retirement account owners to avoid the taxable 10% early withdrawal penalty if they take substantially equal periodic payments (SEPPs) over the course of five years or until age 59 1/2, whichever is longer. These SEPPs are generally calculated using the account owner’s life expectancy, and there are three IRS-approved ways to calculate these amounts. 

How to Calculate SEPP Withdrawals?

The first step in calculating SEPPs is to determine the account balance at the end of last year. This value is then divided by the life expectancy factor chosen in the program’s first year. The annual SEPP is recalculated for subsequent years using the new account balance and life expectancy factor.

Choosing the right method to calculate SEPPs is crucial to avoiding penalties. The IRS approves three methods for calculating SEPP distributions: the required minimum distribution (RMD), fixed amortization, and deferral. Each method has its own benefits and drawbacks.

For example, if you are seeking to meet short-term financial obligations, you may prefer the annuitization method. This uses an IRS mortality table and a fixed interest rate (up to 120% of the federal mid-term rate) to produce an annual distribution amount. However, if you use this method and then modify or cancel your SEPP plan before the required time period expires, you will face substantial IRS penalties. If you are unsure which method to choose, consult a tax professional. They can evaluate your situation and recommend the best method to avoid penalties.

The Amortization Method

Amortization is a method used to pay off loans, such as mortgages and car payments. It involves dividing the loan amount into multiple payments and recording each payment as an expense. This method reduces the overall cost of the debt and allows borrowers to save money on interest charges. There are several types of amortization, including straight-line, accelerated, and declining balance methods. In each type, the periodic payment includes a combination of principal and interest. The proportion of each payment applied to interest decreases over time, and the remainder is applied to principal.

Amortization is useful in two main situations: when taking a personal loan and in business. Intangible assets like licenses and trademarks have a finite useful life, and companies need to assign value to them so that they can deduct their costs from income. The best way to do this is by amortizing them over their useful lives.

The first step in the amortization process is to calculate an asset’s residual value. This is done by subtracting the original purchase price from the asset’s total cost and dividing that number by the asset’s lifespan. This calculation is easy enough for most people to do on a calculator or spreadsheet program. The next step is recording the amortization of the company’s financial statements. This is usually done by debiting the expense account and crediting the intangible asset account.

The Minimum Distribution Method

The minimum distribution method requires an annual withdrawal from an IRA account of at least the required minimum distribution amount (RMD) determined by using a life expectancy table. The RMD amount is calculated by dividing the account balance at the end of the prior year by the owner’s life expectancy factor, which must be recalculated each year. It is an alternative to the fixed amortization and fixed annuitization methods and allows for greater flexibility in the calculation of SEPP withdrawals.

The Annuity Method

The annuity method calculates a fixed annual amount for the entire series of payments. It factors in your total account balance, an annuity factor from an IRS mortality table, and a federal mid-term rate. You can choose between three different annuity tables to calculate your payment: single life expectancy, uniform lifetime, and joint and survivor.

Another advantage of this method is that it does not change with investment performance. However, the payments are not guaranteed. If you terminate your SEPP plan before a minimum of five years or before reaching age 59 1/2, you will incur penalties and taxes on the remaining withdrawn funds.

While the annuity method does not require as many calculations as the other two, it is more complicated and unsuitable for asset purchases characterized by significant additions and extensions. This is because the calculation process requires a formula to determine the cost of the new addition and the amount of interest that would have been earned on the original capital investment had the money not been spent.