The "series of substantially equal periodic payments" exception to the 10% premature IRA distribution penalty is a tricky one.
The reviews are in for the new edition of Natalie Choate's bestselling book Life and Death Planning for Retirement Benefits (7th ed. 2011): "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "I love the 7th edition!" "It's paid for itself already by answering several questions." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about the new edition of Life and Death Planning for Retirement Benefits, visit http://www.ataxplan.com.
Taking an IRA or plan distribution prior to age 59½ normally results in a 10% penalty--in addition to the income tax on the distribution. There are more than a dozen exceptions to the penalty, but they are tough to qualify for. One that every IRA owner can use (but that can be difficult to stick to) is the "series of substantially equal periodic payments," or "SOSEPP." The series of payments are sometimes called "72(t)" payments, but that's a misnomer. § 72(t) of the Internal Revenue Code is the section that imposes the 10% penalty. The SOSEPP exception is actually found in § 72(t)(2)(A)(iv).
This reader has a SOSEPP problem:
Question: "Herbie" lost his job in 2010. He needed to start taking distributions from his IRA to pay living expenses, so he set up a "series of substantially equal periodic payments." Working with his accountant, we figured out, using the IRS' permitted payment methods, that Herbie's IRA would support a SOSEPP of $3,600 a month. At $3,600 a month, based on the IRS's prescribed interest rates and mortality assumptions, the IRA would theoretically run out of money at the end of Herbie's life expectancy.
However, of course, under the SOSEPP rules, he would not actually have to keep taking the monthly payments for his entire lifetime. He would only have to take the distributions until the later of the date he reached age 59½ or five years after the beginning of the SOSEPP. After that point is reached, he could discontinue the series payments, or take more or less than $3,600 a month, without worrying about the penalty.
Unfortunately in December 2011 he needed extra money and took an extra $20,000 out of the IRA. He realizes this has "busted the SOSEPP," and he now owes the IRS the 10% penalty (plus interest) on all the payments he has taken. Since he's been taking the payments for 18 months, that's $6,480 of penalty on the SOSEPP payments (18 months times $3,600 times 10%) plus a $2,000 penalty on the extra $20,000 payment taken in December 2011 (total penalty = $8,480).
He will reach age 59½ in September 2012. He proposes to start a new "SOSEPP" right now, in early 2012, because he still needs monthly income. Does that make sense?
Answer: The "series of substantially equal periodic payments" (SOSEPP) exception to the 10% premature distributions penalty is tricky, as Herbie has discovered. At first it seems simple: Using the IRS-blessed payment methods, interest rates, and mortality assumptions, you set up a series of monthly (or quarterly, or annual) payments that theoretically (if continued exactly until the end of your life expectancy) would reduce the IRA to zero. Then you just keep taking those payments regularly like clockwork, until you pass the magic "home-free" date, which is the later of (1) the date you reach age 59½ or (2) the fifth anniversary of the beginning of your SOSEPP. After that, you can stop the payments, or take larger or smaller payments, or do whatever you want, with no more worries about the 10% penalty.