PRE-591/2 Funding Strategies

How a SEPP can close and income gap and fund insurance premiums while avoiding the 10% penalty

by Russ Towers, JD, CLU, ChFC

Your 52 year old client is considering a $500,000 direct rollover from a previous employer’s 401(k) plan to a deferred annuity IRA with income rider. Some carriers offer annuity income riders that allow up to a 10% withdrawal annually without any surrender charges.

Your client also needs life insurance coverage to protect the family and offset the youngest child’s college costs and the remaining mortgage on the primary residence if your client dies prematurely.

And additional income is needed immediately to close the gap caused by the lower salary being paid to your client by the new employer.

Generally, taxable withdrawals from IRAs and other qualified plans before the participant attains age 59 ½ are subject to an additional early withdrawal penalty tax under IRC Section 72(t). However, if taxable withdrawals are taken in the form of “substantially equal periodic payments” (SEPP), the 10% penalty tax will not apply to the distribution (IRC Section 72(t)(2)(iv)).

In order to qualify, the SEPP must:

•  be distributed at least annually;
•  be calculated as a life expectancy payout;
• continue for a minimum of 5 years or until age 59 ½, whichever is later.

The three methods which can be used to satisfy SEPP from IRAs and other qualified retirement plans according to Revenue Ruling 2002-62 are:

1. The Fixed Amortization method which produces a fixed dollar amount to be distributed annually
2. The Fixed Annuitization method which produces a fixed dollar amount to be distributed annually
3. The Required Minimum Distribution method which produces a variable dollar amount to be distributed annually that is considered being “substantially equal”.

If your client chooses method #3 (the required minimum distribution (RMD) method), the IRA balance as of December 31st of the prior year is divided by the appropriate table factor. Pre-59 ½ SEPP using the RMD method may choose either the Uniform Distribution Table or the Single Life Table – the exact same tables that are used for post-70 ½ RMDs to participants and their beneficiaries.

If your client picks the Uniform Table or the Single Life Table, your client cannot later switch midway through the distribution period to another SEPP method. However, if your client picks the fixed amortization method or the fixed annuitization SEPP method, your client is allowed a one-time change in the future to one of the RMD type of SEPP methods.

Here’s a summary of the SEPP methods available to increase income which avoids the 10% penalty tax on the pre-59 ½ withdrawals from the IRA:

• Fixed Amortization … $22,136 fixed every year for at least 8 years
• Fixed Annuitization … $22,038 fixed every year for at least 8 years
• RMD Uniform Table … $11,211 variable based on each December 31st account value of the IRA for at least 8 years
• RMD Single Life Table … $15,480 variable based on each December 31st account value of the IRA for at least 8 years

Summary and resulting choice of SEPP

Your client decides to choose the fixed amortization method which will produce a fixed SEPP payment of $22,136 and avoid the 10% penalty. The after-tax amount of about $15,000 could be allocated to $11,000 of additional income to help close the salary gap and $4,000 of annual premium for a no-lapse guaranteed UL policy. This annual outlay of $4,000 will purchase a no-lapse guaranteed death benefit of about $350,000 from a competitive carrier to pay off the remaining mortgage and college costs if your client dies unexpectedly. If your client survives long enough for the college costs and the mortgage to be paid off, the internal rate of return (IRR) at life expectancy on the tax free death benefit is an attractive alternative to the current low yields on other fixed financial products.