What You Need to Know About Substantially Equal Periodic Payments

You probably know that if you take a distribution from your IRA before you reach age 59½, then in most cases you’ll be subject to a 10% penalty on that amount of the distribution, in addition to any taxes that may be due. (Distributions from a traditional account are generally subject to income tax, while distributions from a Roth account are not.)

You may also know that there are a handful of circumstances in which you can make an early withdrawal from your IRA and avoid the 10% penalty, but not avoid any taxes that are due. These include certain distributions to assist a first-time home buyer in making a down payment, paying for medical expenses, and paying for certain types of higher education expenses.

In certain limited sets of circumstances, these exemptions from the 10% early withdrawal penalty can be useful for certain individuals. But what about IRA owners who find themselves in a extremely serious financial situation that justifies taking money out of their retirement account – is there another option for those individuals?

Fortunately, there’s another option for taking penalty-free distributions that’s far less known. The holder of an IRA can begin taking distributions from their account as part of a series of what is known as “substantially equal periodic payments.”

The “substantially equal periodic payments” exemption allows the account holder to calculate a yearly amount that they can withdraw from their account every year, for at least five years, or until they reach age 59½, whichever is later.

Given the scope of this exemption, it’s essential for an account holder to be completely sure the withdrawal schedule works for them, and that they’ll be able to maintain and build their overall retirement nest egg to adequate levels. Think about this for a moment, a 25 year old who chooses to take a series of substantially equal periodic payments from their account must do so for more than 32 years. Stopping the withdrawals before they reach that point will subject the account holder to significant IRS penalties.

There are three basic methods for calculating the amount of the periodic payments; the “fixed annuitization method” and the “fixed amortization method.” Under a fixed annuitization approach, the account holder uses a life expectancy table and a “reasonable” interest rate (which will be at least as great as 120% of the federal midterm rate). The fixed amortization method uses a simple amortization approach, and generally yields a lower annual payout amount than the fixed annuitization method. The third approach is to use the same method as that for calculating the required minimum distributions that apply to traditional IRAs for account holders age 70½.

The biggest difference between the third method and the first and second methods is that the amount of the annual payment amount can vary greatly from year to year, depending on the investment activities that occur within the account.

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