What is SEPP? (Substantially Equal Periodic Payment)

Even the most far-sighted people must understand that life is like a wheel in an amusement park. Some days it is very high and in others, it could fall. This is a reality, especially in the financial field. Do you think that at any moment a person could lose their job or having to face an important expense that was not budgeted. This is where a SEPP can come in handy.

If this happens and the amount in your savings account is not high enough to cover it, what can you do? Well, requesting a personal loan would be an option, but making a withdrawal from your retirement plan with a SEPP could also be a great idea. After all, through the SEPP you can make an annual withdrawal without having to pay penalties or interest.

But, What is SEPP and how does it work? Does it apply to all retirement plans? Let’s find out!

What is the Substantially Equal Periodic Payment (SEPP)?

The Substantially Equal Periodic Payment, better known by its acronym as SEPP, is a method of distributing funds for the IRA (or any other qualifying retirement plan) that allows the beneficiary to make withdrawals before the age of 59 and a half. age without incurring IRS penalties.

Remember that, in general, when a person withdraws part of the amount of his retirement plan before reaching the statutory age, he has to pay an early withdrawal penalty that is equal to 10% of the amount distributed.

With a SEPP plan, funds are withdrawn penalty-free through specified annual distributions over a five-year period or until the account owner turns age 59½, whichever is later.

Note: Even if the early withdrawal penalty is waived, you will still have to pay income tax on each withdrawal.

What is SEPP?  (Substantially Equal Periodic Payment)

How does SEPP work?

The operation of the SEPP is quite simple. At the beginning you will have to choose between the three methods that IRS approved To calculate distributions with a SEPP: amortization, annualization Y minimum distribution required. Note that each of them will return a different result, since the distribution will not be the same.

The amount you withdraw will be predetermined, that is, it will be previously established and will remain unchanged over the years, with at least two of the three options available.

The IRS always advises people to select the method that best fits their current financial situation.. Why? Because Beneficiaries are only allowed to change the distribution method they use once during the life of the plan. If you cancel the plan before the minimum holding period expires, you will have to pay the IRS a series of penalties that will be issued to you for the exemptions in the distribution of the plan plus interest.

However, you can use any qualified retirement account with a SEPP. The only exception? The 401(k) account you have with your current employer. If you have an eligible account, set up your SEPP agreement through any financial advisor or directly with an institution.

Now that you’re familiar with SEPP, let’s take a look at each plan’s distribution method:

The amortization method

The amortization method will allow you to calculate the withdrawals from the SEPP plan freezing the annual payment amount to be the same during the applicable program years. This amount is determined using the life expectancy of the taxpayer and his beneficiary -if applicable- and a chosen interest rate, which will not be more than 120% of the medium-term federal rate according to IRS orders.

The annualization method

As with the amortization method, the distribution applied with the annualization method will also be unalterable during the term. In this case, the amount will be determined using an annuity based on the taxpayer’s age and the age of his beneficiary, if applicable; in addition to an interest rate chosen in compliance with the same guidelines established by the IRS for the amortization method. The annuity factor is derived using a mortality table provided by the IRS itself.

Minimum distribution required

When the minimum distribution method is used, the annual payment for each year is determined by dividing the account balance by the life expectancy factor of the taxpayer and their beneficiary, if applicable. In this method, the annual amount must be recalculated annually and thus will change from year to year, unlike the previous two methods. Of course, this means that annual withdrawals will be lower than with the amortization or annuitization method.

What advantages does the SEPP have?

Using a SEPP plan can be a boon for those who want or need to tap into their retirement funds early for whatever reason.

Through this plan, you could earn a steady stream of income, without penalties and without having to wait until you turn 59 1/2. What does this mean? In simple words, that during your 40s or 50s you could receive an annual amount of money, finish your professional career and wait for the arrival of retirement.

After age 59½, you can withdraw additional funds from your retirement accounts without penalty. And after 60 – in recent years, in fact – you will qualify to receive all the benefits associated with Social Security and perhaps even a defined benefit pension.

What inconveniences could a withdrawal with SEPP entail?

Like any instrument, SEPP plans also have drawbacks. For starters, they are extremely inflexible. Once you start a SEPP-type distribution or retirement plan, you’ll need to stay on it for virtually your entire life, which could be many years if you start in your 30s or 40s.

During that time, you will have little or no room to change the amount you can withdraw from your fund each year.. Of course, leaving the plan would not be an option either – at least not such a good one. since they will impose all the penalties you saved with the SEPP, plus interest.

Note: This same penalty can also apply if you make a miscalculation and do not make the necessary withdrawals within a year.

Opting for a SEPP could also have implications for your future financial security. For example, once you start a SEPP, you’ll need to stop contributing to the plan you’re affiliated with, which means, simply put, your money won’t grow with each additional contribution you make.

Also, by withdrawing funds early, you will also be renouncing – even indirectly – the profits that you could obtain for that withdrawn money, along with the tax you would save with each of those earnings that, if they stayed in the retirement plan, would be accumulating tax-free within the account.

In short, what is the SEPP and how does it work?

Now that we have delved into the SEPP and how each of the withdrawal methods work, let’s make a recount that summarizes the most important of this financial chapter:

  • A SEPP plan is nothing more than a way that allows you withdraw funds without penalty from one of your retirement accounts before you reach age 59 1/2, which is the age set by the IRS.
  • The amount to be withdrawn each year will be previously determined by formulas established by the IRS itself. In some cases it could be fixed or unalterable and in others not.
  • If you leave the SEPP plan before it ends, you will be required to pay all penalties that the plan allowed you to avoid, plus the interest generated on those amounts.
  • A SEPP plan is suitable for those who need a steady flow of money before retirement, perhaps to make up for a race that ended early or to cover some unexpected expenses.

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