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Effectively Taking Early IRA Distributions Without Penalty

Natalie Choate simplifies the decision making that come with SOSEPPs.

IRA distributions made to IRA owners before they reach age 59 1/2 are generally subject to an extra 10% penalty in addition to regular income tax. There are about a dozen exceptions to the tax (distributions that can be taken penalty-free). The most popular for planning purposes is the "series of substantially equal payments" (SOSEPP). If IRA owners design their "series" of payments in accordance with strict IRS rules, and keep taking their series payments regularly without any "modification" until they are over age 59 1/2 (and for at least five years), the SOSEPP payments are penalty-free.

IRS rules offer three methods of designing the SOSEPP (annuitization, amortization, minimum distribution), a choice of interest rates (anything up to 120% of the applicable federal rate), and a choice of life-expectancies over which the series payments will be computed (single, joint with beneficiary, or Uniform Table). (The series is computed based on the assumption of a lifelong payout, even though payments can be discontinued once the age 59 1/2/five-year requirement is met.)

This sounds complicated--but the secret is, in almost every case, there's really no need to struggle with these choices. Your clients need to get the largest possible payments allowed by IRS rules. This means they should use a single life expectancy, because a joint life payout cannot produce larger payments than a single life payout. And the highest permitted interest rate, because that produces larger payments than a lower rate. And the amortization method, because it produces larger initial payments than the RMD method and it's easier to calculate than the annuitization method.

Most clients seeking a SOSEPP are either very rich or very poor, like the clients in the following examples.

Earl E. Ret Example
Earl E. Ret, age 45, seeks to retire early and finance his living expenses by drawing down regular payments from his $20 million IRA No. 1. Earl's advisor has determined that an IRA of merely $6 million would support a SOSEPP in the amount Earl needs for his living expenses. That amount is transferred out of IRA No. 1 into a new IRA (IRA No. 2) from which the SOSEPP payments are made. This leaves $14 million in IRA No. 1, which is not involved in the SOSEPP, and which now becomes Earl's "reserve" IRA. This separate "reserve" IRA can be tapped, if needed, for Earl's later needs.

For example, suppose in the third year of the SOSEPP that he is receiving from IRA No. 2, Earl needs an additional $50,000 over and above what the SOSEPP is paying him. He could take a one-time payment of $50,000 from IRA No. 1 (on which he would pay the 10% penalty--$5,000) without being deemed to have "modified" the SOSEPP from IRA No. 2. Or suppose he determines after a few years that the payout he is receiving from IRA No. 2 is not enough for his living expenses after all. He can use all (or, by carving out another new separate IRA, part) of IRA No. 1 to start a second SOSEPP.

Because it is to Earl's advantage to keep as much money as possible in the "reserve" IRA No. 1, his advisors designed his SOSEPP from IRA No. 2 using the amortization method (not the RMD method), the highest permissible interest rate, and Earl's single life expectancy to generate the largest possible payout from the smallest possible fund, maximizing the amount Earl can leave in IRA No. 1 for potential future needs.

Les Cash Example
Due to financial reverses, Lester "Les" Cash, age 47, needs cash and his IRA is the only place he can get it. His IRA is not huge like Earl's. Les seeks to get the highest possible payouts permissible under IRS rules because he needs all the money he can get. Like Earl, Les will avoid using the RMD method and will use the highest permitted interest rate to compute his payouts under the amortization method over his single life expectancy.

Working with his advisor, Les divides his IRA into two or three separate IRAs, and starts one SOSEPP from each IRA. Like Earl, Les is using multiple IRAs to have a safety valve. In Les' case, however, there will be no "reserve" IRA--each of his multiple IRAs will be paying him the maximum SOSEPP it can support. But if someday there is an unavoidable need for him to take out more than his two or three SOSEPPs permit, he can take the extra payment just one of the IRAs, thereby "busting" (modifying) one of his SOSEPPs without disturbing the other one(s).


Where to read more: Internal Revenue Code § 72(t) creates the 10% tax on pre-age 59 1/2 distributions and its many exceptions including the SOSEPP. For the rules on how to establish a SOSEPP, see Notice 89-25, 1989-1 CB 662, A-12, as modified by Revenue Ruling 2002-62, 2002-2 CB 710. See PLR 2002-14029 for an example of the "Earl" technique. See also the IRS list of FAQs regarding SOSEPPs at its website; these are to provide "general information and should not be cited as any type of legal authority." There is much more to SOSEPPs than can possibly be covered in a short article like this. For full detail on pre-age-59 1/2 distributions and the SOSEPP exception, see Chapter 9 of Natalie Choate's book Life and Death Planning for Retirement Benefits

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit to subscribe or learn more.