Retiring Early? Here’s How to Tap into Your Retirement Funds Without Facing Hefty Penalties
Typically, individuals who withdraw funds from an IRA or other qualified retirement plans before age 59.5 face a 10% early withdrawal penalty on the amount distributed. However, the Substantially Equal Periodic Payment (SEPP) method under IRS Section 72(t) allows for penalty-free withdrawals from these accounts (unless you are still employed by the company sponsoring the plan) before age 59½, avoiding IRS penalties on the distributions.
Duration of Withdrawal
Funds in SEPP plans can be withdrawn without penalty through specific annual distributions for either five years or until the account holder reaches age 59½, whichever is later. However, income tax on the withdrawals still applies.
How Substantially Equal Periodic Payment (SEPP) Plans Work
You can apply a SEPP plan to any qualified retirement account, except for a 401(k) held with your current employer. Setting up a SEPP arrangement can be done through a financial advisor or directly with a financial institution.
Initially, you must choose from three IRS-approved methods to calculate your SEPP distributions:
1. Required minimum distribution method
2. Fixed amortization method
3. Fixed annuitization method
Each method results in a different calculated annual distribution. With two of these options, the withdrawal amount remains fixed each year.
The IRS recommends selecting the method that aligns best with your financial needs. You are allowed to change your chosen method once over the lifetime of the plan.
#1 Required Minimum Distribution Method
To determine the amount of minimum distribution method, the IRS’s single or joint life expectancy table is used to calculate the dividing factor, which is then applied to the retirement account balance . This technique is considerably different from the amortization approach in that the amount withdrawn is the lowest possible. Also, the payments vary from one year to the next.
The minimum distribution method used to retire early with 401(k) is the same as the Required Minimum Distribution (RMD) you hear about where account holders with large IRA balances are forced to take a withdrawal after age 72.
Refer to IRS Publication 590-B for the life expectancy tables to calculate the distribution amount. As per the table, a 45-year-old individual has a remaining life expectancy of only 38 years. If that statistic isn’t one of the good reasons to retire, I am not sure what is!
#2 Fixed Amortization Method
For the Fixed amortization method, the IRA owner’s account is amortized over single or joint life expectancy to determine yearly payment amounts, adjusted annually. This method creates the most significant and affordable amount an individual can use to retire early with 401(k). Also, the amount is fixed annually.
#3 Fixed Annuitization Method
The final withdrawal strategy per the SEPP rule is the Fixed annuitization method. The IRS uses an annuity factor to calculate equivalent or nearly equivalent payments. The annual withdrawal using this approach falls between the highest and lowest amounts that you can take from an account.
The distribution amount is calculated using an annuity based on the taxpayer’s age, and the age of their beneficiary if applicable, along with a selected interest rate, following the same IRS guidelines as the amortization method. The annuity factor is determined using a mortality table provided by the IRS.
Advantages of Substantially Equal Periodic Payment (SEPP) Plans
A SEPP plan can be highly beneficial for those who need or wish to access their retirement funds early. It provides a steady, penalty-free income stream in your 40s or 50s, helping to bridge the gap between the end of your career (and regular paycheck) and the onset of other retirement income sources.
Once you reach age 59½, you can withdraw additional funds from your retirement accounts without penalty.
Starting at age 62, you’ll also be eligible for Social Security benefits.
Disadvantages of Substantially Equal Periodic Payment (SEPP) Plans
Commitment to the Plan’s Duration: Once you initiate a SEPP plan, you are required to adhere to its terms for the entire duration, making the plan inflexible. If your financial situation changes, you must still continue with the scheduled distributions until the plan’s completion, which could limit your ability to adjust your retirement strategy.
Withdrawal Amount: The amount you withdraw is predetermined when you set up the plan and cannot be changed. This lack of flexibility means that, regardless of your changing needs or market conditions, the withdrawal amount remains the same, which could be restrictive if unexpected expenses arise.
No Additions or Subtractions Allowed: Once you initiate a SEPP program on a retirement account, you are not permitted to make any additional contributions or withdrawals from the account. This also applies to nontaxable rollovers into other retirement accounts. Any changes to the account balance—aside from the SEPP distributions, gains, losses, and required fees like trade and administrative fees—could result in a modification of the SEPP program and may lead to disqualification by the IRS.
No Option to Exit the Plan Early: Once you begin a SEPP plan, quitting or exiting the plan before it ends is not allowed. If you do decide to stop the plan early, you will face significant financial penalties, including the retroactive imposition of all the penalties you initially avoided, along with interest on those amounts.
No Additional Contributions: The account balance in a SEPP plan does not grow through further contributions, as additional deposits are not allowed once the plan is in place. This means that the funds in the account are limited to what was originally invested, potentially reducing the overall growth of your retirement savings.
Can You Take SEPP Withdrawals From Your 401(k)?
if you are still working for the employer that sponsors the 401(k) plan, you cannot access the funds for SEPP withdrawals. But if you are no longer employed by the company, you can withdraw from your 401(k) through a SEPP program.
What Is the Difference Between SEPP and Rule of 55 Withdrawal Method?
The advantage of the 72(t) method over the Rule of 55 is that there are no age restrictions, and you can do it at any age. SEPP is very popular among early retirees.
The drawback of 72(t) compared to Rule of 55 is the lack of flexibility in the withdrawal amount and schedule. You need to stick to the payment schedule for five years or until you reach age 59.5, whichever comes later (unless you are disabled or die).
One way to obtain some flexibility with the 72(t) rule is to roll over the 401(k) investments into several IRAs. By splitting up your total 401(k) into many IRAs, you could apply the 72(t) to one IRA.
Related post: Retire early using rule of 55
Should I Sign-up For SEPP Withdrawals?
A SEPP plan is ideal for individuals who require a steady income stream before retirement, particularly if their career ended earlier than expected. Or for early retirees who want to access their retirement funds before age 59.5 and avoid paying the penalty.
SEPP withdrawals is also a great strategy for individuals who have accumulated substantial assets in their pre-retirement accounts and want to avoid being hit by Medicare surcharge premiums due to Required Minimum Distributions (RMDs)
However, if you exit the SEPP plan before its completion, you’ll be liable for all the penalties you initially avoided, along with interest on those amounts. Hence one must be confident in their decision before starting withdrawals under IRS section 72(t).
Since the IRS rules for withdrawal are complex and harsh penalties are imposed for any withdrawal errors, consult a licensed professional to create your early retirement income strategy.
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The 10 States Taxing Social Security in 2024 and the 2 That Just Stopped
As 2023 tax filing season draws to a close, retirees across the nation are adjusting their financial plans for 2024, but a crucial detail could drastically alter the landscape of retirement living: the taxing of Social Security benefits. While many bask in the belief that their golden years will be tax-friendly, residents in ten specific states are facing a reality check as their Social Security benefits come under the taxman’s purview. Conversely, a wave of relief is set to wash over two states, marking an end to their era of taxing these benefits. This shift paints a complex portrait of retirement planning across the U.S., underscoring the importance of staying informed of the ever changing tax laws. Are you residing in one of these states? It’s time to uncover the impact of these tax changes on your retirement strategy and possibly reconsider your locale choice for those serene post-work years. Here are the states taxing social security benefits.
The States Taxing Social Security in 2024 and the 2 That Just Stopped
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Retire Abroad and Still Collect Social Security? Avoid These 9 Countries Where It’s Not Possible
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Survey Reveals Americans Now Need $1.46 Million for Retirement, Up 53% Since 2020 – How Does That Compare to Actual Savings?
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SECURE Act 2.0 and Its Impact on Your Retirement Savings: What You Need to Know
Three years post the transformative SECURE Act, its successor, SECURE Act 2.0, extends access to retirement plans and benefits. Updates feature automatic enrollment in workplace plans, increased catch-up contributions for seniors, and expanded savings avenues for part-time workers. It also improves emergency savings access, aiming to bolster financial security. Here’s an overview of the latest provisions impacting retirement planning in America.
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Is the 4.28% Treasury I Bond Rate Still a Wise Investment Choice?
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Is the 4.28% Treasury I Bond Rate Still a Wise Investment Choice?
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John Dealbreuin came from a third world country to the US with only $1,000 not knowing anyone; guided by an immigrant dream. In 12 years, he achieved his retirement number.
He started Financial Freedom Countdown to help everyone think differently about their financial challenges and live their best lives. John resides in the San Francisco Bay Area enjoying nature trails and weight training.
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