Retiring Early Without Early Retirement Penalties
By David C. Valente
Tarlow Breed Hart & Rodgers, P.C.
Income tax deferral can serve as a powerful tool in accumulating and preserving wealth by postponing taxes on earnings, allowing more of said returns to grow on a compounded basis over time. This suggests that a taxpayer should avoid withdrawing funds from a retirement plan, except to the extent necessary, as doing so would diminish the assets that would otherwise grow on a tax-deferred basis. However, there may be situations where a client’s assets are largely illiquid or otherwise inaccessible, such that a withdrawal from a retirement account may be an attractive option.
Generally, under IRC §72(t)(1), a 10% surtax is imposed on distributions from qualified retirement plans 1 defined in IRC §4974(c), to the extent such amounts are includible in taxpayer’s gross income. However, IRC §72(t)(2) sets forth several exceptions to this rule, including without limitation, payments made to a taxpayer 2 after he or she has attained age 59½; those made to a beneficiary (or taxpayer’s estate) on/after the death of the taxpayer; those made for certain medical expenses or on account of taxpayer’s disability; those made to an alternate payee pursuant to a qualified domestic relations order; and, those made (from an IRA only) for qualified higher education expenses or qualified first-time homebuyer expenses of the taxpayer, taxpayer’s spouse, children or grandchildren. A lesser-known exception involves distributions that are part of a series of substantially equal periodic payments (“SEPPs”), the focus of this article.
Consider the following example: husband, age 50, and wife, age 45, have two children in middle school. Their living expenses exceed their net income from their new jobs, so although they have significant net equity in their residence, their cash flow deficit precludes them from refinancing their mortgage. They do not want to downsize for another five to six years, to ensure their children can remain in the same school system through high school. They have 529 college savings plans, term insurance, universal life insurance (with only nominal cash value) and modest bank accounts. Husband has retirement plans with significant balances funded through pre-tax contributions.
Husband could begin to take a series of SEPPs from his retirement accounts, and though the payments would be subject to income taxes, the 10% penalty may be avoided. Once he begins taking SEPPs, he must receive at least one payment per year for five years or until he reaches age 59 ½, whichever is longer. Once the period has elapsed, he can change the payment amount or stop withdrawing entirely. If payments are modified (other than because of death or disability) within that period, then the exception would not apply, meaning the 10% penalty would be imposed (along with interest, retroactively, on all payments), though Rev. Rul. 2002-62 permits a one-time change in limited circumstances. As a result, he needs to commit to a payment period which lasts the longer of five years or until his age 59 ½.
Rev. Rul. 2002-62 provides three methods by which payments may be calculated: the required minimum distribution method; the fixed amortization method; and, the fixed annuitization method. All three methods require the use of life expectancy or mortality tables. The latter two methods require the taxpayer to choose an interest rate, which may be any interest rate that is not more than 120% of the mid-term applicable federal rate for either of the two months immediately preceding the month in which the distributions begin.
If husband was to elect the required minimum distribution method, and assuming his retirement account is valued at $1 million in June of 2019, then using his single life expectancy, payments would be $29,240 in year one, and (assuming no change in account value) $30,030 in year two on account of husband having aged a year, and would fluctuate based on changes in account value and husband’s increasing age. The advantage of the required minimum distribution method is that it is straightforward; however, it usually results in the lowest required payout, and the payments will vary in value year-to-year. Often, an individual considering SEPPs will prefer payments which do not fluctuate year to year.
If husband was to use the amortization method, his life expectancy and choose 2.37% (May 2019 mid-term AFR) as the interest rate, payments would be $43,000 in year 1 and would not change in subsequent years due to husband being older or the value of the retirement account changing. If instead husband was to utilize joint life expectancy, payments would be $37,237 annually.
Finally, if husband was to utilize the fixed annuitization method, payments would be $42,865 in year 1, and would not change in subsequent years due to husband being older or the value of the retirement account changing. Consistent annual payments when utilizing the amortization or annuitization method may be considered a benefit to the taxpayer in that it provides a predictable income stream.
According to the IRSs “FAQs” regarding SEPPS, if the retirement plan is fully depleted prior to the requisite period (the longer of five years or until the taxpayer has reached age 59 ½), the taxpayer will not be subject to the 10% tax. The three methods described above are not the only acceptable ways for determining SEPPS; another method may be requested in a private letter ruling. However, if the taxpayer wanted to solve for a particular dollar amount, the retirement account could be split prior to commencing SEPPs from only one portion. For example, if husband only needed half of the $42,865 annually, he could divide the $1 million account into two accounts each having a balance of $500,000, then commence SEPPs from one of the two accounts so that the resulting payment would be approximately half of the $42,685.
One potential pitfall is that the taxpayer cannot add to the account through contributions, asset transfers or rollovers while taking SEPPs from the account. If husband was to commence SEPPs from an IRA, and his financial advisor subsequently moved to a new firm, husband should refrain from moving the account to the advisor’s new firm, as Rev. Rul. 2002-62 provides that the taxpayer cannot make a “nontaxable transfer of a portion of the account balance to another retirement plan” without triggering the 10% penalty. Taxpayer also cannot take additional withdrawals from the account used to calculate the SEPPs, which is another reason to consider dividing the account into two (if possible) prior to commencing SEPPs.
Given the strict rules relating to SEPPs, clients who need to draw down on assets should consider alternatives to SEPPs, whether liquidating non-qualified assets, or relying on another exception set forth in IRC §72(t)(2). However, SEPPs are one tool which practitioners should keep in mind as a way in which to access retirement funds while avoiding the 10% penalty, whether to finance an ongoing deficit, or to retire early.
