Generally, taxable withdrawals from non-qualified deferred annuities before the participant attains age 59 ½ are subject to an additional early withdrawal penalty tax. Learn more about avoiding this penalty and helping your clients close an income gap.
Within the past year, Ted Eller was let go by Acme Consulting after working for them for the past 22 years. Fortunately, within 8 month, he secured a new job at The Lambda Group.
Here’s the Challenge for Ted:
Ted is 52 years old, married, needs life insurance coverage to protect his family. In addition, he wants to offset the youngest child’s college costs, and is committed to taking care of the remaining mortgage on the primary residence, in the event something happens to him. While he is excited and grateful for landing this particular position, his new salary is 15% lower than what he was making before. As a result, Ted needs money to close the income gap and to fund his insurance premiums.
Ted is considering a $500,000 direct rollover from his previous employer’s 401(k) plan to a deferred annuity IRA with income rider. In some cases, but not all, carriers offer annuity income riders that allow up to a 10% withdrawal annually without any surrender charges. If the individual, in this case, like Ted, is younger than 59 ½, taxable withdrawals from IRAs and other qualified plans 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)).
Here’s where you, his financial professional, can help:
In order to qualify, the SEPP must:
(1) be distributed at least annually;
(2) be calculated as a life expectancy payout;
(3) continue for a minimum of 5 years or until age 59 ½, whichever is later.
There are 3 ways to satisfy SEPP from IRAs and other qualified retirement plans according to IRS Revenue Ruling 2002-62. They include:
(1) Fixed Amortization—produces a fixed dollar amount to be distributed annually
(2) Fixed Annuitization—produces a fixed dollar amount to be distributed annually
(3) Required Minimum Distribution—produces a variable dollar amount to be distributed annually that is considered being “substantially equal”
If Ted opts for Required Minimum Distributions (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 Ted were to pick the Uniform Table or the Single Life Table, it’s important to note that he cannot decide to switch midway through the distribution period to another SEPP method. However, if he picks the fixed amortization method or the fixed annuitization SEPP method, he is allowed a one-time change in the future to one of the RMD type of SEPP methods.
|Using Ted as our example—age 52 with a $500,000 401(k), here’s a look at the SEPP methods available to increase his income and avoid the 10% penalty tax on the withdrawal from the IRA:|
|Fixed Amortization||$18, 591||fixed for 8 years|
|Fixed Annuitization||$18,438||fixed for 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
Based on his financial needs and goals, Ted has decided to choose the fixed amortization method that will produce a fixed SEPP payment of $18,591 and avoid the 10% penalty. The after-tax amount of about $13,000 could be allocated to $9,000 of additional income to help close the salary gap, as well as $4,000 of annual premium for a no-lapse guaranteed UL policy. This annual outlay of $4,000 could 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 Ted were to die unexpectedly. If Ted were to live 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 for him compared to the current low yields on other fixed financial products.
|BSMG Advanced Sales can help calculate the pre-59 ½ SEPP YOU need to best help YOUR client. Our Annuity and Life Insurance Advisors can help you illustrate the most competitive fixed and indexed products available on the market today. Call BSMG at 800-343-7772 today to discuss a case or feel free to reach out to Russ Towers, Vice President Business & Estate Planning directly.|
Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning