Guide to Taking Substantially Equal Periodic Payments (SEPP) From Your IRA Before Age 59 ½

Many doctors are waiting until they reach age 59 ½ to retire because they mistakenly think they can’t take any money out of their retirement accounts until then without paying a 10% penalty.  The IRS rule 72(t) provides the instructions on how to start using the money in your IRA penalty free by taking substantially equal periodic payments (SEPP). If you are retired, you can roll your retirement money into an IRA and follow these rules. I recently rolled my company 401(k) into a rollover IRA and have started to withdraw it using this 72(t) rule.

I retired from medicine at age 54. In the beginning, I lived off the money I collected from being bought out of various physician owned businesses. Those payments have now come to an end. My wife and I decided to go ahead and begin using our retirement funds now while we are young and physically able to travel. We certainly don’t need the money to get by, but if we don‘t spend it, the accounts will just keep growing and we will be the richest people in the cemetery. I’d rather have more great memories.

Like every other government program, this one comes with a lot of red tape, restrictions, and ways to screw up and owe penalties. So here is what you need to know in order to use your IRA funds before you are 59 ½ without encountering penalties.

1: You must follow one of the three methods the IRS has established to set your withdrawal rate. Once you decide which of the three methods you will use, you must follow that plan for either five years or until you reach age 59 ½, whichever is longer. I am starting my SEPPs at age 56 so I will have to stick to the plan for the next five years, making the last withdrawal the year I turn 60. Once I finish this and am in the age 59 ½ -70 ½ window, I can withdraw any amount I want, from zero to all of it, without penalty. After age 70 ½, I will have to meet the required minimum distribution rules. All withdrawals require an income tax payment unless they are coming from a Roth account. Following are the three methods to set your withdrawal rate:

1A: Required Minimum Distribution: This is the easiest calculation. Divide your account balance by your current life expectancy from an appropriate actuarial table. You can use any number of your IRA accounts, but you must use the total value of each account you choose. This calculation must be recalculated every year using your new account balance and your new life expectancy. Even though the withdrawal figure will be changing annually, by sticking to this method, you will be considered in compliance with the SEPP rule.

1B: Fixed Amortization: Using this method, you will determine a fixed annual withdrawal that will deplete the account or accounts you have selected by the end of your life expectancy, based on a projected interest rate which you select. This method, locks in your initial calculation and each year your withdrawal amount will be the same for the entire SEPP period.

1C: Fixed Annuitization: This turns your retirement account into an annuity that would pay out a fixed annual amount during your life expectancy, taking into consideration the account value and the interest rate you predicted. This method generates close to the same withdrawal amount as option B using a more complicated calculation.

2: Even though the plan seems very rigid, having the ability to choose some of the variables allows you to have a great variation in the amount of money you can withdraw. I wanted to pull out 4% of all our retirement funds combined, not just my IRA accounts. This 4% rule has been found to be sustainable for your entire retirement period. I was able to manipulate the numbers to end up with my 4% target. I could have picked variables that resulted in a higher or a lower withdrawal rate but I wanted to stick to the 4% rule.

2A: The first variable to manipulate is the total amount of money you are going to use for the calculations. You must use the entire balance of any account for the calculations, but you do not need to use all of your retirement accounts in the calculations. For example, if you have three IRA accounts, you can use the balance of one, two, or all three accounts for your calculations. You will not use any of the other account types, such as 401(k), in the calculations.

I have two different IRA accounts and my wife has another. Using both my accounts in the calculation gives a larger SEPP figure. I could lower the calculated figure by using only one of the accounts or raise it by using the same process with my wife’s IRA. If you have all your money in one account, and the calculation generates a higher withdrawal rate than you want, then open another IRA account and roll some of the money into the new account. Set one of the accounts to an amount that will calculate a SEPP payment that meets your retirement income needs.

2B: The second variable you can manipulate is the interest rate used to calculate your long term expected return. The IRS realizes that everyone invests differently so they allow each person to use the rate which they believe their investments will yield. This interest rate is chosen by you and changes the calculations accordingly. The interest rate must be a reasonable rate of return. You can’t pick a 75% interest rate, for example.

120% of the Mid-Term Applicable Federal Rate (MTAFR) of interest is the highest interest rate that can be used. The MTAFR is published monthly. The Mid-Term rates are the averages of all money instruments that have a maturity of 3-9 years. For the month of June 2018, the MTAFR was 2.86%, and 120% of that is 3.44%.  You can use the MTAFR from either of the last two months. So using June 2018’s MTAFR to set your interest rate, you can choose any rate between zero and 3.44%.

2C: The last figure you can manipulate is whether you use only your life expectancy, or combine your life expectancy with the life expectancy of your spouse. There are several life expectancy tables you can choose from to give you the average number of years left in your life given your current age. Using the last to die concept, both of your life expectancies, will lengthen the payout and reduce the withdrawal rate.

The ability to manipulate the life expectancy by using either one or two people, the starting balance, and the interest rate, means you have a lot of leeway in coming up with your final calculated figure. The highest withdrawal figure can be reached by using only your life expectancy, the grand total of all of your IRA accounts, and the highest interest rate allowed. The lowest figure will be calculated by using the combined life expectancy of you and your spouse, your smallest IRA account, and zero interest.

I used an online calculator that did all the calculating for me at backrate.com. (https://www.bankrate.com/calculators/retirement/72-t-distribution-calculator.aspx) I do not have an affiliation with them. With this calculator, I manipulated each of the variables to see the results for each option until I found the figure that was closest to the amount I wanted to withdraw.

Using the parameters that gave me the highest possible withdrawal rate from my two IRA accounts produced a withdrawal of 5.5%.  When that figure is spread over all my retirement money, it equates to an overall 4% withdrawal rate, which was my ultimate target.

3: Once you have established your withdrawal rate method and have used it to calculate the amount to withdraw annually, you must take that amount divided into equal monthly, quarterly or annual installments. There is a provision for changing this number if the market crashes and you wish to take out less. Even their rigid terms have some flexibility.

In my case, method B’s calculated payment was about twice the size of method A’s. So, if a market crash occurs, and my portfolio falls to half its size, and I become worried about depleting my retirement accounts to rapidly, I could switch to method A, which would drop my withdrawal in half, and allow me to recalculate it each year based on the actual account balance, reducing the speed of which my account is depleting. The number of years you will be taking payments will not change though.

4: The next step is to transfer the money out of your IRA. Simply contact the company that holds the account you wish to use for your withdrawals. I did it all online by checking a few boxes. You are allowed to take that distribution from any one of your IRAs. This is one of the few areas where I found the government did something that made my life simpler.

Tell them you wish to make an early withdrawal using the SEPP program. They will ask if you want any taxes withheld. (I had them take out my estimated taxes) You can take all the money now, or have them withhold both federal and state taxes at any amount you choose. Let them know how frequently you want the money distributed; annually, quarterly, or monthly. Then tell them where you would like the funds distributed. They can either mail a check to your home or transfer the funds to a non-retirement account. This could be another account that you have with them or one located at another institution. If it is in another institution, you will need to link the two accounts together for the ongoing transfers.

5: Finally, wait for your money to arrive and go have some fun.  There are no tax forms to fill out. No one will check your calculations unless the IRS audits you. If you do get audited, be sure you can show them exactly how you calculated your figures. Involving your accountant in the calculation of these figures will help you analyze the options and decrease the chance of making a mistake and incurring a penalty.

Remember, I am not a tax professional, I am a doctor who has done it and I’m sharing what I have learned along the way. I wrote this to inform you that this option is available for those who plan to retire before age 59 ½. Please consult your accountant when beginning this process.

How about you? Have you accessed your retirement funds under the 72(t) rule taking substantially equal periodic payments (SEPP)? How did it go? It was easier than I thought it would be. Pick up a copy of The Doctors Guide to Smart Career Alternatives and Retirement for more useful retirement information.