In case you don’t know what a 72t distribution is, this is shorthand for the Internal Revenue Code Section 72 part t, and the most popular provision of this code section is known as a Series of Substantially Equal  Periodic Payments – SOSEPP for short.

Enough about the code section already.  What is this thing?  A SOSEPP is a method by which you can access your IRA funds prior to age 59½.  In order to take advantage of this rule, you determine the amount of the annual distribution from your IRA (this is done in a prescribed manner, more on this in a bit) and then begin taking the distributions.  Once you start the SOSEPP, you have to keep it going for the longer of five years or until you reach age 59½.

Methods of Distribution

There are three ways that you can determine the amount of the distribution from your IRA, and all are based upon the balance of the IRA account and your age.  The first method is the simplest, known as the Required Minimum Distribution method.

The Required Minimum Distribution method for calculating your Series of Substantially Equal Periodic Payments (under IRC §72(t)(2)(A)(iv)) calculates the specific amount that you must withdraw from your IRA (or other retirement plan) each year, based upon your account balance at the end of the previous year, divided by the life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year. This annual amount will be different each year.

The second method is called the Fixed Amortization Method.  Calculating your annual payment under this method requires you to have the balance of your IRA account, from which you then create an amortization schedule over a specified number of years equal to your life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

The third method is similar to the second, but it is called the Fixed Annuitization Method.  Calculating your annual payment under this method requires you to have the balance of your IRA account and an annuity factor, which is found in Appendix B of Rev. Ruling 2002-62 using the age you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under one of the two fixed methods, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

An Important Note

It’s important to know that the amounts you’ve calculated are and will be the exact figures for your payments from the account, no more, no less.  It’s not allowable to simply name your own amount and take that each year – you have to use the prescribed amount from one of the methods.

The way to impact the amount of the payment is to adjust the balance in the IRA.  If you have more than one IRA available, you can rollover funds into one account and therefore increase or decrease your payment.  This has to be done prior to establishing the SOSEPP though – it’s not allowed to deposit money into or remove funds from your IRA while the SOSEPP is in place (well, other than the required payments from the account each year).

Any deviation from the prescribed payments will cause the SOSEPP to be “busted”, which can result in some not-so-nice consequences – which you can read more about here.  For more about the SOSEPP, see the IRA Owner’s Manual.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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Most of the time, when taking a distribution from a 401(k) or other Qualified Retirement Plan (QRP) prior to age 59½, there generally is a 10% penalty that applies.  That is, unless one of the exceptions applies – hardship primarily, although there are others.

If you happen to be over age 55 when you leave employment, there is another exception that applies.  Any distribution that you take from the QRP, as long as you were at least 55 years of age when you left employment, will not be subjected to the 10% penalty, only ordinary income tax.

This provision only applies to QRPs, not to IRAs.  So if you’re leaving employment at or after age 55 but before reaching 59½, it can be in your best interest to not rollover your QRP to an IRA, at least until after you reach 59½.  Even if you don’t need the money right away, it could be beneficial to have the source of funds available penalty-free.

For retiring police, firefighters and medics, the age for this exception is 50 – so these folks can take distributions from their QRPs after age 50 if they’ve left employment without penalty.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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In general, when you withdraw funds from an IRA prior to age 59½, your withdrawal is subject to both income tax and the 10% early withdrawal penalty.  The 10% penalty is waived if your withdrawal is for one of the exception categories, including first-time home purchase, certain medical expenses, and the like.  For a complete list of the exceptions, see the article I had previously written which provides links to the various exceptions to the 10% penalty.

One of the exceptions to the penalty is a withdrawal for a Roth Conversion.  You still must pay tax on the conversion, but generally the 10% penalty will not apply to amounts converted from a traditional IRA to a Roth IRA.

However (and there’s always a however in life), there are a couple of situations where the 10% penalty could impact you as you enact your Roth Conversion.

Funds used to pay the tax

If you used some of the funds from your Roth Conversion to pay the tax on the conversion, then effectively those funds were not converted.  Therefore, if you’re under age 59½, the 10% penalty will apply to those funds that you used to pay the tax on the conversion.

For example, if you converted $50,000 from your traditional IRA to a Roth IRA, and pulled out $5,000 to pay the tax on the conversion, then you really only converted $45,000 into the Roth IRA – and the $5,000 was withdrawn for other purposes – and therefore subject to the 10% penalty.  The entire $50,000 withdrawn from the traditional IRA would also be subject to ordinary income tax.

Funds withdrawn within the first five years

When you convert funds from a traditional IRA to a Roth IRA and you’re under age 59½, the converted funds are restricted from withdrawal for the lesser of five years or until you reach age 59½.  If you withdraw the converted funds from the Roth IRA prior to the date the restriction is lifted, your withdrawal will be subject to the 10% penalty.

This restriction is in place to keep a taxpayer from converting funds to a Roth IRA prior to age 59½ (avoiding the 10% penalty) and then immediately withdrawing the funds from the Roth IRA account, thereby affecting a withdrawal from the traditional IRA without penalty.  By causing a delay for such withdrawals of up to five years, this strategy will lose its luster for someone who is hoping to use it to his advantage.

It does provide a way for an individual to do some advance planning if he or she chose to do so, though…

Advance Planning Strategy

Imagine if you were age 50 and hoped to retire in five years.  You have a traditional IRA, amounting to $250,000, plus a pension and a 401(k) plan at your employer.  You know that you’ll need $50,000 per year to live on during the years of age 55 to 60 – so you could convert $50,000 per year for the next five years, paying the tax from other sources.

Then you would have $50,000 per year available to you, beginning at age 55, that would be totally free from tax and penalty, since the conversion occurred more than five years in the past.  Then, when you reach age 60 you’ll have unencumbered access to your other sources of income (since you’re over age 59½), and in a few years you’ll have Social Security available as well.

It’s not a strategy that will work for everyone, but in certain circumstances it might work well for you.

NOTE: You’d want to plan this out very carefully so that you don’t trip up on any of the conversion dates and your future withdrawal dates.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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However, in some cases your old 401(k) plan may have access to desirable investments that you couldn’t otherwise access, or possibly you have access to other benefits from participation, such as availability of a financial advisor.  As long as the overall costs remain low in the plan, you might want to leave the funds there.  Plus there are also some additional benefits inherent within 401(k) accounts that are not available to IRAs – you can read up on the reasons to leave your money in the 401(k) in the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k).

On the flip side, there are certain things that you can’t do in a 401(k) (or other Qualified Retirement Plan) that you can ONLY do with an IRA while you’re under age 59½.

IRA-Only Options

With an IRA, there is no penalty for withdrawal for (click the link following each for more detail):

• Health Insurance Premiums while unemployed – §72(t)(2)(D)
• Qualified Higher Education Expenses – §72(t)(2)(E)
• Qualified First-Time Homebuyer Expenses – §72(t)(2)(F)
• Qualified Reservist Distributions – §72(t)(2)(G)

And none of those are available without penalty from your 401(k).  Of course you would have to pay tax on the distribution, but otherwise you can take the money for those purposes.

In addition, setting up a Series of Substantially Equal Periodic Payments (SOSEPP) is generally easier to qualify for and to set up from an IRA than from a 401(k), so this may be an additional reason to consider rolling over.

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Mistakes With NUA

Moving too quickly – if you roll over your funds from the Qualified Retirement Plan (QRP) without first checking to see if there can be a benefit from the NUA treatment of company stock in the QRP, you’ve lost the chance to do so.  Always check for NUA possibility within the QRP before making any rollover moves.

Not moving quickly (completely) enough – if you have determined that NUA treatment can benefit your situation, you must move ALL of the funds from the QRP within the same taxable year.  If you moved your NUA stock out first and planned to rollover the rest of the account into an IRA or other employer plan, you must follow through within the tax year – delaying even one day beyond the tax year end will break the NUA option and cause the distributed stock to be fully taxable.

Taking RMDs in an earlier year – if you retired in an earlier year, and began taking Required Minimum Distributions (RMDs), once that tax year ends and you have not taken your Lump Sum Distribution to enact the NUA option, you no longer have the NUA option available to you.  This is due to the fact that the NUA option is available ONLY after a triggering event, and the entire balance must be withdrawn in a single tax year.  If another triggering event were to occur – disability or death – then the NUA treatment could still be available.

Selling out of NUA-potential stock in the QRP – if you have significant holdings of your company’s stock in your QRP, chances are at some point you’ll get nervous about holding too much stock in a single company.  Obviously, you don’t want to overexpose yourself to a volatile stock – but it may not make sense to sell all the stock, either.  If the stock has appreciated over a significant period of time, you might want to maintain a position simply to take advantage of the NUA treatment.

On the other hand, if you’re concerned that the stock is going to drop like a rock, (remember Enron? Worldcomm? CitiGroup? Countrywide?) you should ignore the concept of NUA altogether – you shouldn’t let tax laws wag the financial responsibility dog.  Besides, if the stock drops there wouldn’t be any NUA treatment anyhow.

Not understanding NUA – if you don’t understand it completely, your chances of getting it right are small.  This is a very strict set of rules (aren’t they all though?) and simple moves in the wrong direction can break the option altogether, potentially causing a major tax hit.  It’s also important for your heirs to understand NUA – or make sure that they will work with your NUA-savvy advisor before they make any moves.

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On the other hand, as a surviving spouse you also have the option of moving the funds from the original account into an account in your own name – which will usually produce better distribution options at your passing, or at least giving you the flexibility to improve the distribution options.  The problem with this move is that once you have moved the funds into your own account, the exception to the 10% penalty for early withdrawal no longer applies.  So, unless one of the other 72(t) exceptions applies you can not access the funds in the new, rollover account until you reach age 59½.

How to Deal With the Dilemma

How should you deal with the dilemma?  It depends completely on your specific situation, but below are some strategies you might consider:

If you’re in dire financial straits without access to the IRA, leave it in your late spouse’s account, at least until you reach age 59½, and then rollover the funds into your own account.  Since there is no deadline for this rollover, you have the flexibility to treat the account in this fashion.  If the event of your untimely death before rolling over the account would produce undesirable distribution requirements, you can address this by purchasing term life insurance with account proceeds, timing the insurance to expire upon your rollover.

If you’re well-to-do (okay, comfortable, or even rich) or in ill health, you should not delay in rolling over the funds into your own account.  This is because when you’ve made this move, you can be in control of the disposition of the account upon your death.  If for some reason you later need to access the funds in the account and you’re still under age 59½, you can either set up a Series of Substantially Equal Periodic Payments (SOSEPP) unless one of the other 72(t) exceptions applies.

What If the Account Requires Lump-Sum Distribution?

If there is a reason to leave the funds in the deceased spouse’s account but the account provisions require that you take a lump sum distribution immediately, you can roll over the account to an Inherited IRA, maintaining the original owner’s name, essentially acting as if you are a non-spouse beneficiary.  This will give you the freedom to begin taking distributions (these are Required Minimum Distributions, RMDs) from the account, without penalty.  Then you can later rollover the funds into your own account at a later date when you no longer need the distributions or you reach age 59½.  This provides you with the option of receiving distributions in smaller amounts and protecting the tax-deferred status as long as possible – in spite of the provision from the original account that required lump-sum distribution.

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Let’s look at the definition from the IRS…

Definition

Only Eligible Rollover Distributions, or ERDs, can be rolled over, according to the IRS.  The definition that is given is really an anti-definition, explaining that any normally taxable distribution is eligible for rollover unless it fits the exceptions listed.

An ERD is defined as – a distribution that is eligible to be rolled over to an eligible retirement plan. Eligible rollover distributions include a participant’s balance in a qualified plan, 401(k), 403(b) or 457 plan, except for certain amounts that include the following:

• Any of a series of substantially equal periodic payments (SOSEPP) paid at least once a year over:
  • The participant’s  lifetime or life expectancy,
  • The joint lives or life expectancies of the participant and his/her beneficiary, or
  • A period of 10 years or more,
• A required minimum distribution,
• Hardship distributions,
• Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains,
• A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant’s accrued benefits are reduced (offset) to repay the loan
• Dividends on employer securities, and
• The cost of life insurance coverage.

So, as long as the distribution plan that you set up doesn’t fit any of the requirements above and has a payout period of 10 years or less, your distributions can be considered ERDs, and therefore rolled over into an IRA or other retirement plan.

Understand that these distributions will be subject to mandatory 20% withholding if paid out to you.  Plus, you must complete the rollover within 60 days when it’s not done by trustee-to-trustee (or direct) rollover.

Whenever possible, you would want to set up these payments as direct rollovers into your IRA (or other QRP) to avoid this withholding requirement and 60-day limit.  If this can’t be done, you should make up the 20% withheld difference from other savings as you rollover the distributions in order to avoid tax and penalties.

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Applying Early for Reduced Benefit Amount

When you apply early (before your FRA), a formula goes into effect to determine how much your benefit will be reduced.  First, determine how many months there are between your FRA and the age at which you’ll start receiving benefits.  The PIA will be reduced by a percentage based upon the number of months you come up with.  The first 36 months are multiplied by 5/9 of 1%, and any months beyond 36 are multiplied by 5/12 of 1%.

So, if your FRA is age 66, and you intend to begin receiving benefits in the month that you are age 62 and 6 months, your PIA would be reduced by 20% for the first 36 months (36 * 5/9% = 20%) plus an additional 2½% for the remaining 6 months (6 * 5/12% = 2½%) for a total of 22½%.  The maximum amount that the PIA can be reduced is 25% for folks with FRA of age 66, ranging up to 30% for those with FRA of age 67.

When you come up with this reduction factor, it is then applied to your PIA, and the result is your anticipated benefit amount.  You can see in the table below how waiting a few months or years can make a big difference to the benefit amount.  And this change can have a huge impact on your lifetime benefits – because once you start receiving your benefit, it won’t change other than with the annual COLA increases – unless you continue to work while receiving benefits, which could increase your PIA.  The other way to increase your benefit is to take the “do over” – described here.

Delaying Receipt of Benefits to Increase the Amount

If you are delaying your retirement beyond FRA, you’ll increase the amount of benefit that you are eligible to receive.  Depending upon your year of birth, this amount will be between 7% and 8% per year that you delay receiving benefits – which can be an increase of as much as 32½% if you delay until age 70 and you were born in 1941 – when your FRA is 65 years and 8 months, and the increase amount is 7½% per year at that age.  See the table below for the increase amounts per year based upon birth year:

So you can see the impact of delaying receipt of retirement benefits – it can amount to more than 50% of the PIA, when you consider early benefits versus late benefits.  Of course, by taking benefits later, you’re foregoing receipt of some monthly benefit payments; given this, early in the game you’d be ahead in terms of total benefit received.  This tends to go away as the break-even point is reached in your mid-70′s to early-80′s in most cases, which we’ll review in a later article.

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Steps to Set Up a SOSEPP

The first step in setting up a SOSEPP is to figure out just how much you’ll need to take each year.  In the best of all circumstances, your SOSEPP plan will take small enough payments that it will not exhaust your IRA funds… Working with a financial advisor or an actuary, you can figure out how much money is required to support the SOSEPP payments that you require.

Once an amount is determined, a new IRA can be opened and the money required rolled over into that account.  Other IRAs and 401(k) accounts will then hold the remainder of your funds – which provides your savings for future needs, once the SOSEPP is no longer in effect, or a “safety valve” for you to use in the event that you need additional funds at some point.  Of course, taking an additional amount from one of these other accounts would require payment of the 10% penalty (unless one of the other exceptions applies) – but this is much better than taking too much from your SOSEPP IRA and busting the plan, which carries some heavy penalties.

Keep in mind, especially if you’re setting up your SOSEPP early in your life, it will be possible to set up another SOSEPP from a different account should the need arise.  You would just have two series’ going on at the same time, with different variables impacting each series.

In other cases, you may just want to take the greatest possible payment that you can from your collective plans, which can be easily determined when the span of the plan is understood, given your age and the amount in the IRAs.

Several choices are necessary to set up the plan:

• Choose one of the three permitted methods – RMD, amortization, or annuitization
• Choose a life expectancy table – single, joint, or uniform life expectancy
• Choose an interest rate (if using amortization or annuitization)
• Decide whether to use annual recalculation (if using amortization or annuitization)
• Choose the account balance valuation date
• Determine the “period” for your payments.  These can be monthly, quarterly or annually, but must at least be annual, and must be at the same regular interval each “period” once set up.

All of these details must be attended to when setting up the plan, and careful attention should be paid when making these decisions.  If you set up such a plan early in your life (say at age 50 or earlier) you will have to live with your choices for a considerable amount of time.  Understand what each choice means and can mean in the future as you make these decisions.

For more information on the SOSEPP – including all of the methods, the life expectancy tables, and all of the other details, see the IRA Owner’s Manual.

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Withholding Rule For Indirect Rollovers

In general, if you take an early withdrawal (pre-age 59½) from an IRA or a Qualified Retirement Plan (QRP) that includes pre-tax money, the custodian of the account is required to withhold and pay to the IRS 20% of the pre-tax amount withdrawn.  This can still be a tax-free transaction if you finish the indirect rollover process correctly and place the entire amount of the distribution back into an IRA or QRP within 60 days.  However, if you don’t complete the indirect rollover, you’re likely to get a tax surprise…

A transaction like this is called an “indirect rollover”, as opposed to a direct or a trustee-to-trustee rollover.  In the event that you complete the indirect rollover within 60 days, you will need to come up with the 20% that was withheld in order to have a full rollover – otherwise you’ll have to pay tax and a penalty on the amount that was not rolled over.

An Example

For example, let’s say you’re 50 years of age, and you have a 401(k) from a former employer that you’d like to roll over into your IRA account.  The 401(k) is worth $50,000.  For whatever reason, you opted to have the 401(k) custodian send you a check for the amount, which you then plan on sending to the IRA custodian for deposit (within the allowable 60 day period, as an indirect rollover).

Lo and behold, when the check arrives, it’s only made out for $40,000!  This is because the custodian was required to withhold 20%… and so now, since you don’t have any savings to speak of, you can only send the $40,000 over to the IRA custodian.  Guess what?  Come tax time, you will have to include that “lost” $10,000 as income, plus you’ll get to pay a 10% early withdrawal penalty as well.  So if you’re in the 25% tax bracket, you get to pay $3,500 in tax and penalties (25% times $10,000 plus 10% times $10,000).

Now, the original 401(k) that was worth $50,000 is reduced to an IRA worth $40,000 and a tax refund of $6,500 (since $10,000 was withheld and your tax and penalties were only $3,500).  This swift little maneuver has cost you 7% of your retirement plan!  Plus, you’ve lost tax-deferral on $10,000…

ALWAYS Do the Direct Rollover

It is for this reason that, whenever possible, you always should do a direct, or trustee-to-trustee transfer when rolling over IRA and QRP funds to a new account.  When you do a trustee-to-trustee rollover, no withholding applies, so you don’t have to make up any difference, and your tax-deferred amount remains intact.

It’s important to note that in our example above, if you had the $10,000 available to you in savings or elsewhere to make up the difference for the withholding, you could still complete the indirect rollover without tax or penalty by sending a total of $50,000 to the IRA custodian within 60 days.  Then when you file your taxes for the year, that $10,000 withheld would amount to either a refund to you or a reduction in the amount of tax that you had to pay for the year.

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