Substantially Equal Periodic Payments or How to Avoid 10% Early Distribution Penalty
When an employee who participates in your organization’s 401(k) separates from your company, there are a number of ways they can manage their 401(k) funds. Some options are affected by the age of the participant, specifically if they are younger than 59 ½ years and they want to withdraw their savings in cash. Often such participants must pay a 10% penalty for early withdrawal.
But there are also ways around that penalty. Rule 72(t), issued by the Internal Revenue Service, permits penalty-free withdrawals from IRA accounts and other tax-advantaged retirement accounts like 401(k) plans under certain conditions. But the IRS still subjects the withdrawals to account holder's normal income tax rate.
If your employee separates before the age of 59 ½, there is a way that they can use to avoid the 10% penalty. This can be done through what is called Substantially Equal Periodic Payment (SEPP).
SEPPs allow the participant to receive payments from the 401(k) plan without the 10% early distribution penalty if the participant is between the ages of 55 and 59½ years. The catch is that the participant (or beneficiary) must continue to receive the SEPP for five years or until s/he turns age 59 ½. In addition to that, the participant must not make any modifications to the SEPP within this five year period. Otherwise, a 10% penalty will be applied on all amounts paid, plus interest for the deferral period. In any case, the participant may still owe federal and state income tax on their distributions.
Once your employee decides to start taking distributions in the form of SEPP, there are IRS-approved payment options to calculate how much money they will get during each year: the amortization method, the annuitization method, and the required minimum distribution method. All three methods rely on the use of a life expectancy table.
The fixed amortization method consists of an account balance amortized over a specified number of years equal to life expectancy and an interest rate that can't exceed 120% of the federal mid-term rate. Once an annual distribution is calculated, the same dollar amount is distributed each year.
In addition to the account balance used in the fixed amortization method, the fixed annuitization method also consists of an annuity factor and annual payment. The annuity factor is calculated based on the mortality table (see Appendix B) and an interest rate that can't exceed 120% of the federal mid-term rate. Once an annual distribution is calculated, the same dollar amount is distributed each year. Often, this method results in the largest annual distribution amount.
Required Minimum Distribution
The required minimum distribution (RMD) method consists of an account balance and a life expectancy. An annual distribution is calculated by dividing the account balance as of December 31 of the prior year by life expectancy (single life, uniform life or joint life and last survivor) using attained age(s). So this method is the easiest way to calculate an annual distribution but it has to be redetermined on annual basis. Also, the RMD method usually results in the smallest amount.
Although you may have heard that any 401(k) withdrawals made before the age of 59½ will be subject to early withdrawal penalties, there are a few exceptions. Participants can use SEPPs to access their money before age 59½ if they commit to keeping the periodic payment schedule unchanged for at least five years and if they separate at the age of 55 or older. With exceptions like this, the IRS sometimes makes it a little easier to access your money without penalties.