This article was last updated November 01, 2007.
With the sharp rise in the stock market over the last 20 years, the value of many folk's IRAs
haven't just grown, they've exploded beyond all imagination or
expectation. A few have felt overwhelmed with the prospect of abundant
future cash flow and have asked if it's possible to withdraw smaller sums
from their IRA prior to age 59½. Under current tax law you can withdraw
all the money you want from an IRA before age 59½, but you have to pay
regular income tax on the withdrawal plus a 10% penalty tax.
Is there a tax loophole I can use?
Fortunately, there is a loophole known as a "72(t) exception". Under
current tax law (Internal Revenue Service Code Section 72(t)(2)(a)(iv))
you can avoid the 10% penalty tax if you take "substantially equal
periodic payments." The Internal Revenue Service 1989 Cumulative Bulletin
89-25 on Page 666) tells you how to calculate what it considers to be
"substantially equal periodic payments". IRS Revenue Ruling 2002-62 adds additional details and clarifies some issues pertaining to IRA early withdrawals. All of these engrossing volumes
are very likely available at your local law library.
Can you summarize how this loophole works?
To take a series of "substantially equal periodic payments" (SEPP) from
your IRA without penalty, you must withdraw money at least once a year,
and you must keep taking withdrawals for five years or until you reach age
59½, whichever is longer. So, a 35-year-old must take withdrawals
for twenty-five years, while a 51-year-old must take them for
eight-and-a-half years. A 57-year-old would have to take withdrawals for
five years, until age 62. Also, you must let a minimum of 5 years plus 1
day elapse from the date of your first SEPP withdrawal before making
"unlimited" withdrawals from your IRA, even if you've reached age 59 1/2.
Otherwise, the IRS will hit you with the 10% penalty and retroactive
The amount of your withdrawal is calculated based on the balance of
your retirement account on December 31 of the preceding year or any date in the current year prior to the first distribution using your age on December 31st of the year in which you make the withdrawal.
What if I have money in a 401(k) account instead of an IRA?
You can rollover your 401k account into an IRA after you terminate your
employment. However, there are two reasons this might not be
- You have "highly appreciated" company stock in your 401(k).
If you take a lump sum distribution of all your qualified plans, you
will pay ordinary income tax (plus the 10% penalty if you are under age
55) on the cost basis of your employer's stock held in your 401(k). Any
appreciation is then taxed at the capital gains rate when
you sell the shares. If you rollover the company stock to an IRA, this
option is lost and you pay ordinary income taxes on all
distributions from the IRA.
The clearest discussion I've seen to
date on the issues surrounding company stock in a 401k comes from Dave
Braze (aka TMFPixy) at the Motley Fool, click
here. It's well worth reading.
- You can make penalty-free withdrawals from a 401(k) at age
55. You must wait until age 59 1/2 to make penalty-free withdrawals
from an IRA. While this seems like a big break for a 55-year-old
retiree, there are several things to consider; (1) Your employer
must make it convenient for an ex-employee to make retirement
withdrawals, many employers can't be bothered, (2) Rolling over
your 401(k) funds to an IRA may increase the variety of investments
available to you and lower your fees. If that's the case, the hassle of
SEPP withdrawals from an IRA may be worth it.
is one fine point that many people miss in taking penalty-free
withdrawals from a 401k at age 55. To do so, you must terminate your
employment no earlier that the year in which you turn age 55.
(See IRS Notice 87-13) If you retired at age 54 and waited until age 55
to make withdrawals from your 401k, you would not be able to make
unlimited penalty-free withdrawals. You could only make penalty-free
withdrawals by using SEPP.
What if I have stock options or another non-qualified
Today, many folks have a sizable number of stock options in
addition to their 401(k) and IRA retirement accounts. While
discussion of this topic is beyond the scope of this article, there
is an excellent volume on the subject written by tax attorney Kaye
Thomas. This book offers plain language guidance on all the popular
forms of equity compensation: stock grants, nonqualified options,
incentive stock options and employee stock purchase plans. It also
covers the pitfalls of the alternative minimum tax (AMT) as it
relates to option plans.
Consider Your Options: Get the Most From Your Equity
by Kaye A. ThomasClick
here to order Consider Your Options
248 pages (January 10, 2000)
Fairmark Press, Inc.;
The amount of the penalty-free withdrawals that you can take from your
IRA varies considerably, depending on which of the three IRS-approved
methods you use to calculate the withdrawals. The three methods are 1) the
life expectancy method (also known as the "minimum method"), 2) the
amortization method, and 3) the annuity factor method. Table
One summarizes the advantages and disadvantages of each.
|Table One. Three Methods for
IRA Early Withdrawals|
|Optimal Retiree Age
||Age 30 to 50
||Age 50 to 59
||Age 50 to 59|
|Size of Annual Withdrawal
|Chance of outliving IRA assets
|Adjusts annual withdrawal
changes in IRA asset value
|Difficulty of making
The life expectancy method is outlined on Page 28 of IRS Publication 590, "Individual Retirement Arrangements." The
withdrawal in 2003 would be calculated by dividing the balance of
any or all of your IRAs on December 31, 2002, by your life
expectancy (or the joint life expectancy of you and the beneficiary
of your IRA). The single life expectancy of a 40-year-old, (which
can be found on Page 65 of IRS Publication 590),is 43.6 years. So,
under this method, a 40-year-old with a $100,000 IRA could take
$2,294 ($100,000 / 43.6) from the IRA without paying the 10% excise
tax on premature withdrawals. Next year, the investor would divide
the IRA balance as of December 31, 2003, by 42.7 (the life
expectancy of a 41-year-old). The investor would have to continue
these annual withdrawals until age 59½.
Under the Life Expectancy method, as the balance of your
retirement account goes up or down, so goes the amount you are
required to withdraw each year. This is actually an advantage for
younger IRA holders, since they are not locked into the first year's
withdrawal amount as their IRA balance grows over the next 20 or 30
years. If your IRA balance doubles, the required withdrawal will be
slightly more than double the previous year's withdrawal. Similarly,
if a stock market drop results in the value of your IRA dropping by
50%, this year's withdrawal will be slightly more than half the
preceding year's withdrawal amount.
The amortization method allows you to amortize the balance
of your IRAs over your life expectancy (or the joint life expectancy
of you and your beneficiary), using a "reasonable" interest rate
assumption for earnings on your account. The formula for making this
calculation is as follows:
r ( 1 + r )^E
Annual IRA = P x ------------------------
( 1 + r )^E - 1
where P = IRA Balance on December 31
r = interest rate
E = Single or Joint Life Expectancy (from IRS Publication 590)
Note: 1 is the number one (it does not appear too clearly on some browsers)
and "E" is an exponent of the term "( 1 + r )"
If you have Microsoft Excel, you can use the PMT function to make this calculation.
The IRS has ruled that a reasonable interest rate is anything
less than 120% of the "Mid-Term Applicable Federal Rate" for either of the two months immediately preceding the month in which the distribution begins.The IRS publishes these rates monthly. For December 2002, the Annual Mid-Term Rate was 3.31%. By assuming that the account would earn 120% of that rate, or 3.98%, a
40-year-old with a $100,000 IRA balance could boost the penalty-free
withdrawals to $4,868 per year.
Unlike the "life expectancy" method where you recalculate the
annual withdrawal based on your IRA balance on December 31 of the
previous year, under the amortization method, the withdrawal amount
is fixed in the first year. You don't get to increase the annual
withdrawal for inflation or an increase in the asset value of your
Which Interest Rate Should I Use?
Revenue Ruling 2002-62 is very clear on this issue. A taxpayer may not use an interest rate
that exceeds 120% of the mid-term applicable Federal rate. However, you may use a lower interest rate if you like.
Revenue Ruling 2002-62 also states that you must use the interest rate for either of the two months immediately preceding the month in which the distribution begins. For example, if you make your first distribution in July 2007, you may use either the May 2007 or June 2007 interest rate.
120% Mid-Term Annual Applicable Federal
Readers prefering to get their interest rates directly from the
horse's mouth should go to the IRS web site, under Applicable
use the mid-term annual rates listed in Table 1 of the IRS monthly
interest rate update.
The IRS is frequently late is posting the latest interest rates.
Here's another source for the latest numbers from a Pennsylvania law
firm, see link: http://evans-legal.com/dan/afr.html.
For the convenience of our readers, Retire Early
withdrawals using the Life Expectancy and Amortization methods. To
use the calculator you need three things; 1) your IRA balance
on December 31 of last year, 2) your life expectancy (Click here for
the single life expectancy table, the joint life table appears in
IRS Publication 590. Click here to
download Publication 590 from the IRS Web site.), and 3) the
Mid-Term Applicable Federal Rate which appears in a table
For the annuity factor method, this calculation involves dividing the IRA balance by an "annuity factor"
-- the present value of a payment of $1 per year for your life
expectancy, based on "reasonable" mortality tables and a
"reasonable" interest rate at the time the payments begin. You can use up to 120% of the "Mid-Term Applicable Federal Rate" as a reasonable rate but you must use the mortality table in Appendix B of IRS Revenue Ruling 2002-62.
To assist readers in making the calculation, Retire Early has developed an Excel spreadsheet based on the mortality table
in Revenue Ruling 2002-62, Appendix B. It also includes the
distribution calculation for the amortization and minimum methods
for easy comparison. (Note: For SEPPs beginning on Jan 1,
2003 and after, the Annuity 2003 mortality table must be used.)
Annuity 2003 Calculator
(annu2003.xls size = 40,448 bytes)
Like the amortization method, under the annuity factor method you
don't get to recalculate the amount of your withdrawal each year.
The amount is fixed for five years or until you reach 59½, whichever is longer.
What if I started my SEPP before January 1, 2003?
If you started your SEPP in 2002 or earlier using the UP-1984 Mortality Table, you may continue to use it. Many retirees will prefer to do so since it yields a higher withdrawal than the mortality table in Rev. Ruling 2002-62 Appendix B.
You can download a copy below:
Retire Early Annuity Factor Calculator
(UP-1984 Mortality Table)
(annu984.xls size = 34,816
Important Note: For SEPPs beginning on January 1, 2003 or after, you must use the new 2003 IRS mortality table for the annuity factor method.
In the past, using the UP-1984 Mortality Table, the annuity factor method resulted in withdrawals higher than the amortization method. With the new 2003 IRS Mortality Table that is no longer the case. For all ages and interest rates, the amortization method results in a larger annual distribution.
|Comparison of Minimum, Amortization, and Annuity Factor Methods|
$100,000 IRA balance, IRS 2003 Mortality Table
|Interest Rate >>
or Minimum Method
Annuity Factor Method
After reading the table above you might ask, "Why would I want to use the annuity factor method?" The answer is you probably wouldn't. Since the amortization method yields a larger annual distribution for the same interest rate, you'd want to use that method instead of the annuity factor method.
What if my IRA runs out of money while taking SEPP distributions.
If you have been following an approved SEPP program and losing investments deplete your IRA before age 59-1/2, the IRS will not assess the 10% penalty and retroactive interest changes that usually result upon a modification to the annual distribution. (See Rev. Ruling 2002-62.)
Additionally, if you have been using the amortization or annuity method, you may make a one time change to the Minimum Distribution method. For a given IRA balance, this will reduce the annual distribution and allow the remaining portfolio to last longer. (See Rev. Ruling 2002-62.)
This is good news for those who attempted to take a SEPP using the annuity method with a high interest rate or from a concentrated portfolio and have suffered severe losses. If you invested primarily in something like Enron or WorldCom, your portfolio could be close to zero by now. The opportunity to make a penalty-free change to the minimum distribution method will offer some belated relief -- at least from the IRS penalties.
On the other hand, if you invested in Dell or Microsoft ten years ago and your portfolio has grown appreciably, you could also benefit from a change to the minimum distribution method. For example, let's say a 40-year-old started a SEPP eight years ago in November 1994 when 120% of the Long-Term Federal applicable rate was 9.61%. Using the UP-1984 Mortality Table and the annuity method, the fixed annual withdrawal in 1994 would be $9,456 from a $100,000 IRA. If the portfolio had grown to $1 million today, our now 48-year old retiree could switch to the minimum distribution method and take $27,780 from a $1 million IRA in 2002. That's almost a three-fold increase in the annual IRA distribution without incurring a penalty.
The option to switch to the minimum method may also appeal to those that decide to return to work or receive another source of taxable income that makes it unnecessary to continue their IRA withdrawals. Completely stopping the SEPP withdrawals would result is the application of the 10% penalty to all distributions to date, plus interest. Switching to the minimum method would at least reduce the distribution without triggering the penalty. However, the disadvantage is that you won't be able to change back to the amortization or annuity method at a later date without triggering the 10% penalty.
How do I calculate the amount of the penalty and interest if I decide to stop my SEPP distributions?
You pay the 10% on all distributions to date, plus interest from the date of the distribution to the date you decide to discontinue your SEPP program. Retire Early has developed a simple, easy to use Excel spreadsheet that allows you to estimate the amount of the penalty. It downloads directly as
an Excel file, you don't need to "unzip" it.
"Busted" SEPP Calculator
(seppbust.xls size = 25,600 bytes)
The same penalty applies if you make a mistake in calculating the annual distribution or run afoul of IRS regulations in some other way. Double check your work.
Can I still use annual recalculation or annual inflation adjustments with the amortization and annuity methods?
In the past, there have been several IRS private letter rulings (PLRs) allowing for annual recalculation with the annuity and amorization methods as well as several allowing the annual SEPP distribution to be increased for inflation or "cost of living" (see PLRs 9503631, 9726035 and 9816028.) Revenue Ruling 2002-62 is silent on these method variations.
In 2004 there were two IRS private letter rulings allowing for recalculation using the amortization method ( PLR 2004-32021
and PLR 2004-32024
) and one allowing for recalculation with the annuity factor method (PLR 2004-32023
.) To date, there have been no authoritative published references giving guidance on whether inflation adjustments with the annuity or amortization methods are permissible under the new rules.
The Retire Early Home Page has developed an Excel Spreadsheet you can use to keep track of your annual SEPP distributions using the Amortization Method with Recalculation. Click. here.
If you want to use inflation adjustments for a SEPP starting on or after Jan. 1, 2003, it's probably best to request an IRS private letter ruling on the issue, or wait until another taxpayer spends a few thousand dollars asking the question and the IRS publishes a positive ruling. Then you'll have the answer for free.
How do I notify the Internal Revenue Service of my intention to take SEPP distributions?
Your IRA Custodian will have a form for you to fill out to request an IRA distribution. Make sure you check the box with "Exception Code 2 - Early Distribution Penalty Does Not Apply" or similiar wording if it appears on the form.
At tax time, your IRA Custodian files Form 1099-R with the IRS notifying them that you made an IRA distribution. Your IRA Custodian will also forward you a copy of the Form 1099-R that they sent to the IRS.
The amount of your IRA withdrawal is reported on Line 15a of Form 1040. If you made any non-deductible contributions to your IRA, you can file Form 8606 to determine what portion of Line 15a is not taxable. This lower taxable amount is then reported on Line 15b of Form 1040. If you don't have any non-deductible contributions, then Line 15a and 15b should have the same number.
Starting in 2004, you must also complete IRS Form 5329 to claim the exception to the 10% penalty
Instructions for Form 5329.
You'll also want to save a copy of all your SEPP withdrawal calculations in case you are audited.
Do I have to start my SEPP distributions on January 1st?
No. You may pro-rate the first year's distribution for the remaining months in the year (e.g., starting a SEPP in July would be 6/12ths of the full-year amount.) The IRS calls this a "stub year". In the second and all subsequent years, the full amount of the annual distribution must be withdrawn. (See PLR 200105066) You may also elect to take the full-year amount in the first year if you like -- even if you start the SEPP in December.
The IRS doesn't care how you actually withdraw the money from the account (e.g., 1 annual payment, 12 monthly payments, 52 weekly payments, or any variation thereof.) The only requirement is that the total of all the withdrawals during the year must exactly equal the calculated amount of the annual (or stub year) distribution.
Can I have more than one IRA?
Yes. You may have as many IRA accounts as you like and take SEPP distributions from one, two, or all of them. The only restriction is that you may not add money to an IRA currently undergoing SEPP distributions, or make additional withdrawals beyond the SEPP distribution. Any modifications would trigger the 10% penalty on all SEPP distributions made to date plus back interest charges.
Can I make an additional penalty-free IRA withdrawal such as the one for a first-time home purchase or higher education expenses from an IRA currently undergoing SEPP distributions?
It's unclear. There haven't been any IRS private letter rulings on the issue to date. Because of the large penalty and interest charges that would result if the IRS objected, I'd seek a positive IRS private letter ruling on the subject before proceding.
If I get a part-time job, may I make an annual IRA contribution even though I'm currently taking SEPP distributions from my IRA?
Yes. To the extent that you have wage & salary income (i.e., "earned" income), you may make on IRA contribution up to the annual maximum. However, you may not put the annual IRA contribution in an IRA currently undergoing SEPP distributions. The IRS considers this to be a modification and will assess the 10% penalty plus interest on all distributions to date. You must make the annual IRA contribution to a new IRA, or an existing one that is not undergoing SEPP withdrawals
Do you need to hire a CPA to make the calculation for you?
It depends. The majority of the early retirees I know are able to read and understand the explanation above and are comfortable enough with Excel spreadsheets and arithmetic to make the calculation themselves. But if you currently have a tax preparer doing your return or are afraid of numbers, you may as well pay a few hundred dollars more for him or her to do the SEPP calculation as well.
If you decide to use a tax advisor, it's important to get some kind of guaranty on his work. Here's some sage advice from best-selling financial author Suze Orman:
IRA Early Withdrawals
"Have the firm that will be calculating your SEPP state
on the company letterhead (not the financial advisor's
letterhead) that the company is responsible for calculating
your substantially equal periodic payments and will be
responsible for any mistakes and any penalty incurred."
(Suze Orman, You've Earned It, Don't Lose It -- Mistakes
You Can't Afford to Make When You Retire, p. 109.)