The individual retirement account (IRA) frequently forms an important part of the retirement income strategy of a working person. In fact, because of job switches, rollovers and other developments, it is quite common for all of an employee’s tax-deferred retirement funds to be consolidated into one or more IRAs.
Because IRAs are intended for long-term retirement accumulations and not a short "in and out" tax shelter, the Internal Revenue Service imposes penalties on IRA withdrawals prior to age 59. The penalty is 10 percent of the amount withdrawn and is in addition to the regular income tax. Wisconsin follows suit and imposes an additional 3-1/3 percent penalty.
If a withdrawal from an IRA account is subject to penalties, it is possible to lose almost one-half of the premature distribution to taxes and penalties. For example, with a federal income tax of 28 percent, a Wisconsin income tax of 6 percent, a federal penalty of 10 percent and a Wisconsin penalty of 3-1/3 percent, the total taxes and penalties would be 47.3 percent.
Accordingly, accessing IRA accumulations prior to age 59 and paying both taxes and penalties would drive a stake into the heart of most retirement income strategies. Yet there are times when access to retirement funds prior to age 59 would be entirely appropriate and would not violate the government’s tax policy that such funds should be used for retirement purposes.
Say, for example, where an individual attains age 55, either retires or is laid off or downsized, is unable or chooses not to pursue other employment and needs a retirement income bridge until he or she can commence receiving Social Security at age 62, or begin receiving another company or government pension.
Fortunately, the Internal Revenue Code provides penalty-free access to IRA funds prior to age 59 if the payment or withdrawals are made in a series of substantially equal periodic payments, sometimes abbreviated as a SOSEPP, over the lifetime of the IRA owner.
One’s first reaction to such a proposal might be negative. Why would anyone at age 50 or 55 commit themselves to an inflexible monthly payment from an IRA account which if left until age 59 could be accessed with much more flexibility?
While some people might find such a fixed recurring payment comforting, most people would prefer more flexibility. The series of substantially equal periodic payments that is the legal door to penalty-free, pre-age 59 distributions is not so unforgiving.
To constitute a SOSEPP, the series of payments may commence anytime at any age, but must continue until age 59, or for at least five years, whichever is longer. Thus, if an employee needs access to funds at age 52, the substantially equal payments must continue until age 59. On the other hand, if the series of payments starts at age 57, then the payments must continue until age 62, because at age 59, the payments would not have lasted for the required minimum five-year period.
After the required period has been satisfied, then withdrawals from the IRA can be made in whatever amounts and at whatever time the individual desires. The requirement for making distributions for at least five years (or age 59 if later) helps to ensure that the IRA accounts act like a real retirement income source rather than a tax-deferred pocket of cash that can be accessed whenever the need arises.
How, then, is the amount of the substantially equal periodic payment determined? It should first be noted that the SOSEPP does not necessarily involve purchasing a commercial annuity from an insurance company, although this would also qualify as a way to make penalty-free distributions. In fact, the IRS permits the substantially equal periodic payments to be calculated in one of three ways: the amortization method; the annuity factor method; and the minimum distribution method.
Of these, the amortization method is perhaps the easiest to understand and explain. Under the amortization method, the required substantially equal periodic payment is that distribution which at a required interest rate would exhaust the IRA balance over the life expectancy of the IRA owner. This is similar to a fully amortizing mortgage, except instead of repaying the bank, the IRA owner is paying him or herself.
The IRA owner’s life expectancy is determined by an IRS life expectancy table, and the interest rate is 120% of the applicable federal mid-term rate, an interest rate which the IRS publishes monthly for various tax related financial transactions. If, for example, an individual age 55 with an IRA balance of $300,000 were to start a series of substantially equal periodic payments on May 1, 2004, the term would be 29.6 years, the interest rate would be 3.75 percent and the monthly payment would be $1,400.
The annuitization method, the second way of calculating a SOSEPP, would produce a minimum payment using a government annuity factor.
The minimum distribution method, the third method of calculating a SOSEPP, would produce a variable distribution by dividing the changing account balance by a decreasing life expectancy factor each year.
Accessing funds prior to age 59 through substantially equal periodic payments is a way to provide penalty-free IRA retirement income for a period of time free from IRS premature distribution penalties. It works well at earlier ages as a bridge to other forms of retirement income, such as Social Security or a company pension. Yet what is taken today is not available tomorrow, and early distributions will ultimately reduce funds available for later retirement years.
John T. Bannen is a partner in the Milwaukee office of Quarles & Brady LLP. He focuses his practice on estate planning and probate, employee benefits and taxation.
April 11, 2004 Small Business Times, Milwaukee, WI
