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An updated IRS rule allows the owners of IRAs and other retirement accounts to withdraw more money than before using a Substantially Equal Periodic Payment (SEPP).The costs associated with withdrawing money from a 401(k) or IRA early are well-known. Doing so before age 59.5 means paying a 10% penalty on top of ordinary income tax.

However, there is a lesser-known way to avoid this steep penalty when withdrawing money early from a qualified retirement plan. The Internal Revenue Service permits you to convert retirement assets into an income-like stream using substantially equal periodic payments (SEPP).

And those interested in using a SEPP plan to take early retirement distributions got good news from the government last month when the IRS updated the rules governing this financial maneuver. The end result? The IRS will allow you to withdraw more money from your 401(k) or IRA using a SEPP. Below, we’ll delve deeper into SEPP plans and how the new IRS rule may affect you.

A financial advisor can help you set up a SEPP plan or make other strategic decisions regarding your retirement plan. Find a trusted advisor today.

What is a SEPP and Who Are They Best For?

A Substantially Equal Periodic Payment (SEPP) allows people younger than 59 1/2 withdraw money from their IRA or 401(k) penalty-free.

A SEPP plan is a method for converting retirement assets into annual payments that continue for five years or until you reach age 59.5, whichever comes later. SEPPs can be an effective way to access retirement funds early, especially if you’ve lost your job and/or are approaching retirement age. However, this type of distribution can be complicated and may require the help of a financial advisor.

Distributions from a SEPP are permanent, meaning they cannot be discontinued without paying a penalty. In the event you want to cancel these annual payments, you’ll be subject to the same 10% penalty you would have paid the IRS had you taken regular early withdrawals. The penalty will apply to all of the previous SEPP distributions you received up until that point.

You should also understand that establishing a SEPP means you can no longer contribute to the retirement plan from which you’re withdrawing funds. Not only will you no longer be saving for retirement, but you’ll also forgo any future earnings the money that’s withdrawn might have earned.

Given the rigidity of these plans, SEPPs are not viable for everyone. For example, if a 38-year-old who loses her job considers setting up a SEPP to tap her retirement funds, she’ll receive annual distributions from the account for the next 21-plus years, long after she’s gotten a new job and may no longer need the extra cash.

However, a SEPP may be more suitable for a 55-year-old who is suddenly laid off from a job that he held for 30 years and is unable to get a new one. Instead, he can establish an income-stream through a SEPP that will hold him over until he can take regular, penalty-free distributions from his retirement account.

A SEPP may also be appropriate for someone who has amassed a significant nest egg in his retirement account and wants to retire before age 59.5.

What the IRS Update Means for SEPPs

An updated IRS rule allows the owners of IRAs and other retirement accounts to withdraw more money than before using a Substantially Equal Periodic Payment (SEPP).In January, the IRS issued its Notice 2022-6, which updated how SEPP distributions are calculated. Previously, the interest rate used in SEPP calculations could not exceed 120% of the federal mid-term rate. However, the IRS now allows you to use a 5% interest rate or 120% of the federal mid-term rate, whichever is higher.

This is relevant for people who use either the amortization or annuitization method for calculating their SEPP distributions. The third option is using the calculation for required minimum distributions, which does not rely on a set interest rate.

As estate planning lawyer Natalie Choate noted in a recent column for Morningstar, the impact of this new guidance is dramatic.

“The effect of increasing the assumed growth rate from approximately 1.5% (the current “120% of the federal midterm rate”) to 5.0% produces a dramatic increase in annuity- or amortization-method payments over the long life expectancy of someone younger than 59 and a half,” she wrote.

As a result, a 54-year-old man with $400,000 in his IRA could set up a SEPP in 2022 and receive annual payments of $24,000 using the amortization method, according to Choate’s calculations. That’s significantly more than the $16,000 he would have received under the previous rule.

Bottom Line

A substantially equal periodic payment (SEPP) plan is a lesser-known way to withdraw money early from a qualified retirement account and avoid the 10% penalty. In January, the IRS updated its rule for how some SEPP distributions are calculated by hiking the interest rate allowed in these calculations, resulting in higher SEPP payments.

However, it’s important to remember that SEPPs are complex financial instruments and particularly inflexible, so establishing one takes careful planning and consideration.

Tips for Saving for Retirement

  • A financial advisor can be a valuable resource when it comes to saving for retirement. They can walk you through different types of accounts and strategies, and assess your overall financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Are you saving enough currently? That’s a difficult question to answer for yourself, but SmartAsset’s retirement calculator can give you a clearer picture of where you stand and the growth you can expect in the future.

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Patrick Villanova, CEPF® Patrick Villanova is a writer for SmartAsset, covering a variety of personal finance topics, including retirement and investing. Before joining SmartAsset, Patrick worked as an editor at The Jersey Journal. His work has also appeared on and in The Star-Ledger. Patrick is a graduate of the University of New Hampshire, where he studied English and developed his love of writing. In his free time, he enjoys hiking, trying out new recipes in the kitchen and watching his beloved New York sports teams. A New Jersey native, he currently lives in Jersey City.
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