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'SOSEPP' Problems

The "series of substantially equal periodic payments" exception to the 10% premature IRA distribution penalty is a tricky one.

Natalie Choate, 02/10/2012

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.

So what's the problem? The problem is that any "modification" of your "series" before that magic home-free date has the effect of killing the entire "SOSEPP." You simply lose your qualification for the exception--retroactively to its beginning! So, for example, someone who faithfully took a series of equal payments every month beginning at age 25, but somehow "modified" his SOSEPP at age 58, would owe the 10% penalty retroactively on all payments he had received since age 25! If that seems absurd, well, I agree: It is absurd. But that's what the rules say.

A "modification" means you take more or less than you are supposed to take under the series schedule. It can be something as small as taking a few too many dollars in one payment, or skipping a payment. Although the IRS tends to be forgiving in the case of very small mistakes--especially if they are caused by a financial institution or clerical error and quickly remedied--it may require a private letter ruling to confirm this.

Because of the draconian punishment for modifying a SOSEPP, the best advice is to only use a SOSEPP after careful consideration and with ongoing competent monitoring. Also, try to keep another IRA "in reserve" (i.e., a separate IRA that is not involved in the SOSEPP), so the participant will have a "safety valve"--another account he can tap for any special extra payments needed, or even to start a second SOSEPP. Unfortunately, for many people who need SOSEPPs, like Herbie, the financial need dictates that all of their IRAs must be dedicated to supporting the SOSEPP payments, so there is no reserve account or rainy day fund to cover emergencies. So Herbie had to "bust" his SOSEPP.

Now Herbie wants to know how he can best get money to live on in 2012. Since Herbie will turn 59½ later this year, and does not qualify for any penalty exception other than potentially the SOSEPP exception, here are his choices going forward:

Option 1: Take no distributions from his IRA until he reaches age 59½ in September 2012. Under this option he will owe no 10% penalty. This is the ideal option if he can manage it.

Option 2: Take distributions as needed from the IRA in early 2012, without starting a new SOSEPP, and pay the 10% penalty on each distribution taken before reaching age 59½.

Option 3: Working with his accountant, design a new series of substantially equal payments that starts right now, based on his current IRA balance and age, and the current IRS interest rates and mortality assumptions. Then he can either:

A. Continue the new SOSEPP for five years and owe no penalty; or
B. Abort the SOSEPP sometime before the five years are up and owe the penalty on any distributions taken between now and the date in September 2012 when he reaches age 59½.

Note that the results are exactly the same under Options 2 and 3-B. Thus if he really thinks he might keep the new SOSEPP going for five years, he has nothing to lose by starting a new SOSEPP in 2012 except the costs of professional advice in designing the series. But if he doesn't really think he will keep it going for five years, he might as well bite the bullet and just choose Option 2 and save the accounting fees. Or better yet, use Option 1!

Resources: For more detail on the 10% penalty applicable to distributions before age 59½, and on all the exceptions to the penalty including the SOSEPP, see Chapter 9 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011; http://www.ataxplan.com).

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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