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Sidestep penalties for early IRA withdrawals

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In this current economic crisis, you might have to turn to your IRA to pay the mortgage, a child’s college tuition or other essential expenses. Generally, early distributions (before age 59½) from an IRA will trigger a 10% federal penalty tax, on top of the regular income tax.

Strategy: Arrange to receive “substantially equal periodic payments” (SEPPs). If you meet certain tax-law requirements, the payouts are exempt from the usual penalty, no matter your age.

Here’s the whole story: Normally, an IRA owner must pay a 10% penalty tax if he or she begins taking withdrawals from the IRA prior to age 59½. But there is an exception to the penalty tax for a series of SEPPs lasting at least five years or until you reach age 59½, whichever is later. The payment amounts are based on your life expectancy (or the joint life expectancy of you and a designated beneficiary). 

3 options for SEPPs

The IRS has identified three basic methods for determining SEPPs. If the payment method is substantially modified before age 59½ (or five years, if that’s later) the 10% penalty tax is still imposed.

1. Required minimum distribution (RMD) method: Under this method, the annual payment is determined by dividing the account balance as of the end of the previous year by the number from the applicable IRS life expectancy table for the year. But this procedure results in a different payment amount each year.

2. Fixed amortization method:
With this method, the annual payment is determined by amortization of the account balance over a period of years using a life expectancy table and assumed interest rate.

IRS rules allow you to select between two different life expectancy tables and several interest rate assumptions. The annual payment remains the same year to year.

3. Fixed annuitization method:
The annual payment is determined by dividing the account balance by an annuity factor derived from a reasonable mortality table with a reasonable assumed interest rate. As with the second method, the amount stays constant year to year.

The SEPP exception is applied on an IRA-by-IRA basis. Therefore, if you desire more flexibility, you may divide an existing IRA into several different IRAs before taking any distributions before reaching age 59½. Then you can begin taking distributions from any one of the IRAs. If additional distributions are needed, they may be withdrawn from other IRAs.

Also, you can make a one-time switch from the fixed amortization method or the fixed annuitization method to the RMD method. This may be beneficial if your account has declined in value. As a result, a new lower payment may be calculated based on the reduced account balance.

If you started SEPPs prior to this year, you may benefit from a switch in this volatile economy. 

Tip: The RMD method provides the smallest annual payout while the other two methods generally provide bigger payouts.

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