Calculating IRA 72(t) Payments for the 10% Penalty Exception

If you take distributions from your IRA before age 59 1/2, you will owe the IRS a 10% additional tax unless you qualify for an exception. One of the exceptions applies to distributions that are taken under a substantially equal periodic payment, or SEPP, program—also known as 72(t) payment program. Distributions taken under a SEPP program must follow a strict set of rules, including withdrawing only the required amount each year. Breaking the rules could lead to disqualification of the program, causing a retroactive assessment of the 10% additional tax plus interest.

In this article, we use the case of Jessica to highlight the rules that determine SEPP amounts and the strategies that can help to provide the best results.

Case Study: Jessica’s 72(t) Program

Jessica plans to take distributions from her IRA to cover some expenses.

Her date of birth is Jan. 1, 1974, which means she is under age 59 ½ and will owe the IRS a 10% additional tax on her distributions unless she qualifies for an exception.

Her IRA balance is $1 million.

Jessica plans to meet with her advisor to see if the SEPP program is suitable for her.

The following are some considerations for Jessica.

The Minimum Length of the Program

A SEPP program must continue for five years or until the IRA owner reaches age 59 1/2, whichever is longer. Therefore, if Jessica starts her SEPP program January 2025, she must continue until she reaches age 59 1/2, because the date she reaches 59 1/2 is the later of the two dates.

For this reason, the SEPP program might not be suitable if Jessica needs funds to cover a one-time financial need. If that is the case, Jessica should check to see if she qualifies for any other exception to the 10% additional tax. If not, paying the 10% additional tax on a one-time distribution might be savvier, allowing the balance to grow tax-deferred.

Exceptions to Minimum Duration

A SEPP program that is discontinued before the established deadline will result in a modification, causing a retroactive assessment of the 10% additional tax, plus interest. An exception applies if the discontinuation occurs due to death, disability, or complete depletion of the account.

Calculating the SEPP Amount

The IRS provides three safe-harbor methods for calculating SEPP amounts:

1. The required minimum distribution, or RMD, method.
2. The fixed amortization method.
3. The fixed annuitization method.

Jessica may not use another method unless she gets approval from the IRS to do so.

Interest Rate Used to Calculate SEPP Amounts

For the fixed amortization and the fixed annuitization methods, the annual amounts must be calculated using an interest rate that is not more than the greater of:

1. 5%, or
2. 120% of the federal midterm rate for either of the two months immediately preceding the month in which the SEPP payments begin. Therefore, if Jessica starts in January, she may use the rate for November or December. The federal midterm rates are published monthly by the IRS and posted at https://apps.irs.gov/app/picklist/list/federalRates.html.

The federal midterm rate varies based on the computing frequency, which can be annual, semiannual, quarterly, or monthly. Please see Page 2 of the December rates for an example.

Life Expectancy Table Used to Calculate SEPP Amounts

For the RMD and fixed amortization methods, Jessica may use the Uniform Lifetime Table or the Single Life Table to determine the life expectancy factor to use when calculating her SEPP amounts. If she has a beneficiary, she can also use the Joint and Last Survivor Table.

Fixed SEPP Amounts Each Year

The same amount must be withdrawn each year for the fixed amortization and fixed annuitization method.

For the RMD method, the amount must be refigured each year and will, therefore, change. The IRS explains that this change in amounts is not considered breaking the rules.

Comparing the Results of all Three Methods Is Recommended

Jessica’s advisor performs a SEPP calculation using all three methods based on the following:

• Her IRA balance of $1 million.
• The highest annual interest rate of 5.03%—which is from the December 2024 rate and is higher than the November 2024 rate of 4.45% and the default 5.0% (see above).
• The Single Life Table—which produces the highest amount of all three tables.

Based on these factors, Jessica’s annual SEPP amount would be as follows:

Jessica's Annual SEPP Amount for Each Safe-Harbor Method

Jessica has several options here.

1. She may choose either of the three options—ideally, the one closest to the amount she needs. If she chooses the fixed amortization or annuitization method, she may switch to the RMD method anytime after the first year. That is the only permitted switch.
2. She may use a different life expectancy table. For example, if she used the Uniform Lifetime Table, the amounts in RMD method would be $21,052.63 in year one, and the annual amount under Amortization method would be $55,714.85.
3. She may lower the interest rate, which would lower the amount under the amortization or annuitization method.

Reverse Engineering Is an Option

If Jessica does not want to use the entire $1 million for her SEPP program, she may perform a reverse calculation to get the specific amounts she needs.

For example, if she wants to withdraw only $30,000 per year under the program, she may transfer $540,000 to a separate IRA and operate the program under the amortization method from that (separate) IRA.

Other Rules Apply

The rules discussed in this article focus on determining SEPP amounts. But there are many other rules one must follow to ensure compliance with the program, and breaking any of those rules could result in disqualification of the program for the IRA owner. If you are considering starting a SEPP program, please share IRS Notice 2022-6 with your tax advisor, so that they can ensure the applicable rules are followed.