What You Need to Know About Substantially Equal Periodic Payments

Estimated reading time: 3 minutes

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 72.

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.

Make a Brighter Future For Your Children and Grandchildren by Appointing a Trust as Your Self-Directed IRA Beneficiary

Estimated reading time: 3 minutes

You start saving for retirement to take care of yourself, right? You want to be sure that you and your spouse can lead a safe and comfortable lifestyle during your retirement years, so you set up a self-directed IRA and make regular contributions to it.

But at the core of all saving and investment there’s likely to be something more. After all, most people tend to keep saving and investing even after they’ve got enough to take care of themselves. We often tend to continue making these savings and investment choices because we’re thinking beyond ourselves and our spouses. We believe that with our saving we can benefit our children and our grandchildren, and help to improve their lives.

One technique that some individuals use is to name a trust as the beneficiary of their self-directed IRA. The rationale, particularly if they’ve already created the trust for other reasons, is that a trust beneficiary will give them greater control over their estate planning. Here are some considerations for appointing a trust as the beneficiary of your self-directed IRA.

Make Sure You Have a Good Reason. Naming a trust as a beneficiary will invariably involve more paperwork and planning than simply naming the individuals that you want to benefit. In order to make this worthwhile, you want to be sure that you have a good reason for involving a trust in the handling and administration of your self-directed IRA assets.

One common reason to name a trust as your beneficiary is if you don’t want your children or grandchildren to have immediate access to the full amount of your bequest. Trusts can be set up to make periodic payments to the individuals you name, or to make payments for certain purposes (such as college expenses, for example), so that the assets you’ve accumulated will not be spent too quickly.

Spousal Beneficiaries. The spousal rollover provisions for IRAs are very powerful, and the benefits are might outweigh anything you may be able to gain from having your spouse benefit from a trust that’s the beneficiary of your self-directed IRA. Speak with your advisor to weigh the pros and cons of each approach.

The Trust Beneficiaries. Avoid the temptation to make your structure overly complicated. For example, the beneficiaries of your trust should be individuals, and not additional trusts or charities. For example, any structure that has the effect of completely avoiding taxes that would otherwise be due is likely to draw examination from the IRA.

Furthermore, if there are a number of different children and grandchildren that you wish to help, consider setting up separate trusts for each individual. You may also wish to divide your self-directed IRA into multiple accounts in order to feed into each of these trusts. The costs can be a disincentive for some, but don’t be tempted to try to cut corners. Getting something wrong can have immediate and significant negative tax implications.