Frequent questions arise around what constitutes the dreaded "modification" of an IRA SOSEPP.
Taking an IRA or plan distribution prior to age 59 1/2 normally results in a 10% penalty--in addition to the income tax on the distribution. There are more than a dozen exceptions to this "premature distributions" 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).
Under the SOSEPP exception, payments made before age 59 1/2 that are part of a SOSEPP are exempt from penalty. The series can be designed using any of several IRS-approved methods. However, if the series is "modified" in any way prior to attaining age 59 1/2 (or within five years of starting the series, if later), the exemption is lost retroactively.
Frequent questions arise around what constitutes this dreaded "modification" of a SOSEPP. Here are two that came in this month.
Question: "Wolfgang," age 57, has been taking a "series of substantially equal periodic payments" (SOSEPP) from his IRA for the last eight years. The SOSEPP payments of $3,000 per month were determined using the IRS "annuity" method. Unfortunately, due to low interest rates and unfavorable investment results, the IRA is now down to $12,000, and it clearly is going to run out of money before he reaches age 59½. If he stops taking the payments because the IRA runs out of money, would that be considered a "modification" of the SOSEPP, making him liable for the 10% penalty retroactively on all prior payments?
Answer: Here is good news about your bad investment results: The IRS anticipated this problem and lets Wolfgang off the hook if his account runs out of money.
The IRS recognizes that, if investment performance is poor, fixed payments under the amortization or annuitization method might exhaust the account. Accordingly, the IRS has ruled that running out of money due to taking the payments called for by the SOSEPP will not be considered a "modification" of the series. See Rev. Rul. 2002‑62, § 2.03(a).
There is actually a similar exception under the minimum distribution rules: An individual's minimum required distribution from a particular IRA or account is, in any year, the amount determined under the usual minimum distribution formula for such year (see Chapter 1 of Life and Death Planning for Retirement Benefits for how to compute annual required distributions) or, if less, the entire value of the account at the time of the distribution. If the account value has plunged (whether due to investment results or some other cause--such as a divorce court awarding the entire account to your ex-spouse) so that the total value has shrunk below the amount of the required distribution, the required distribution is reduced to not exceed the account value. See Treas. Reg. § 1.401(a)(9)-5, A-1(a).