Substantially Equal Installment Payment Rules

Take-Away: One way to avoid an early distribution 10% excise tax on a distribution from an IRA or qualified plan account is to abide by the substantially equal periodic payment exception under the Tax Code. The problem with following that exception is the longer of five years or age 59 ½ requirement.

Background: According to the Government Accountability Office, at least $69 billion in retirement funds were withdrawn by individuals ages 25  to 55. These withdrawn amounts were subject to the 10% early distribution excise tax unless at least one exception to the excise tax applies. One major exception to the 10% early distribution penalty is when distributions are taken as substantially equal periodic payments, or SEPP’s.  However, SEPP’s are subject to a strict set of rules that must be followed, otherwise the 10% penalty is applied retroactively to the first distribution. [IRC 72(t).] One key factor to consider in a SEPP arrangement is that the IRC 72(t) payments must continue for five years or until the account owner attains the age of 59 ½ years, whichever event is longer. Due to this ‘5-year or longer’ rule, if the retirement account owner’s financial need is imminent or of a smaller amount, it might be better for the account owner to simply  ‘bite the bullet’ and take a distribution and pay the 10% excise tax, in lieu of being locked-in to a long installment payment period.

Example: Clyde, age 55, owns an IRA with a balance of $1.0 million. Clyde intends to take an early distribution from his IRA (since he is under age 59 ½.)  If Clyde took a lump sum distribution from his IRA, he would incur a 10% excise tax ‘penalty’ of $100,000, in addition to the income tax liability that he would have to report, presumably at the 37% marginal income tax bracket since all the taxable IRA distribution would be bunched into a single calendar year. That 10% penalty could be avoided if Clyde took his $1.0 million in substantially equal payments, and possibly expose the distributions to a lower marginal federal income tax bracket.

Rules: Several rules must be followed for a successful SEPP to avoid the 10% early distribution excise tax.

1. Use Another Penalty Exception First, if Possible: Other exceptions to the 10% penalty might be available. If so, they should be used, first. For example, distributions from an employer sponsored qualified plan are exempt from the 10% early distribution penalty, if the plan documents provide: (i) the  plan participant’s employer with the plan sponsor ended in the year that the participant reached age 55 years, and the plan participant took distributions after the termination of employment. There are other exceptions, albeit limited, to the early distribution penalty for both IRAs and qualified plans, e.g. higher education expenses for IRAs only. The point is that if another exception applies, it might be better to exploit the other statutory exception which does not force the account owner to take period distributions over a long period of time.

Example: If Clyde held his $1.0 million in his former employer’s profit sharing plan, he could take the distribution after he terminated his employment, and since he was over the age 55, avoid incurring the 10% on his lump sum distribution. Clyde would still have to pay income taxes on that lump sum (37% bracket) but he would avoid the additional 10% excise tax for an ‘early distribution.’

2. IRS’s Distribution Formula Must Be Followed: IRC 72(t) provides three separate safe harbor methods used to calculate periodic payments: (i) the required minimum distribution (RMD) method; (ii) the fixed amortization method; and (iii) the fixed annuitization method. Each method requires complex computations and software to ensure accuracy in calculating the annual amount to be paid . An IRS-approved interest rate must be used for the amortization and annuitization methods. That rate is capped at the greater of: (i) 5%, or (ii) 120% of the federal mid-term rate for either of the two months that immediately precede the month in which the SEPP distribution begins. [IRS Notice 2022-6.]
3. Payments Must Be the Same Each Year: Once an account owner starts their SEPP distributions, the payments must continue using the calculation method that was initially selected for the duration of the SEPP period. However, there is a one-time opportunity to switch from the either the annuitization or the amortization method to the RMD method of payment. Obviously, with the annuitization and amortization safe harbor methods, the periodic payments determined in the first year will be the same amount that must be distributed for each calendar year of the SEPP period. With the RMD method, the actual amount after the first year will be different because that amount will be re-determined each year.
4. Payments Must Be Taken Annually: SEPP distributions  may be taken annually, quarterly, or at another frequency, but no longer than annually Taking a SEPP payment every other year is not permitted.
5. Payments Must Continue Until Later of 5 Years or Age 59 ½: Once the account owner starts taking their SEPP payments, the payments must continue for 5 years or until the account owner attains age 59 ½ , whichever is the longer period. If payments cease before this deadline, all the penalties previously waived under the SEPP arrangement will be owed to the IRS, plus interest. The penalties and interest are waived, however, if the account owner dies, becomes disabled, or the account balance is depleted due to taking the SEPP payments.
6. No Other Distributions Permitted: Unless the account owner qualifies for another exception, no other distributions may be made from the retirement account from which SEPP distributions  are taken. These limited  exceptions are listed in IRC 72(t). Moreover, no new funds can be added to the SEPP retirement account, and no transfers can be made from the SEPP retirement account unless the transfer is for the entire balance, i.e. when the transfer is made to a new account from which the SEPP payments continue.

Conclusion: The usual advice to a retirement account owner is to not take distributions from an account that was created, and funded, to provide for the owner during their retirement years. That said, there are some occasions when the retirement account must be accessed to address a financial hardship that cannot be avoided. In those rare occasions when a retirement account must be accessed to deal with emergencies, all other exceptions to the early distribution excise tax should be explored before turning to substantially equal periodic payments from a retirement account. The risks associated with SEPP’s are large if one or more of these rules is violated, leading to income taxes, the 10% excise tax, and interest assessed on the excise tax.