New IRS Rules Help Young IRA Owners
IRA owners under the age of 59.5 now may be able to withdraw penalty-free money from their accounts.
Get Morningstar's essential reading for financial professionals in Advisor Digest.
IRS Notice 2022 6, issued in January 2022, has dramatically improved the ability of IRA owners under age 59 and a half to withdraw penalty-free money from their accounts using a "series of substantially equal periodic payments," or SOSEPP. Though new longer life expectancies slightly reduce the maximum initial payment under a SOSEPP, a substantial increase in the permitted interest-rate assumption (to 5%) significantly increases it.
As the young well know, a person who withdraws money from an IRA while under age 59.5 faces not only income tax on the withdrawal but a 10% "additional tax" (usually referred to as a "penalty") on the withdrawn amount simply because he or she is deemed not old enough to start taking money from a retirement account. The penalty fulfills its purpose of discouraging early withdrawals but also punishes those who need access to their own money sooner than expected because of life circumstances. Most of the dozen-plus exceptions to the penalty apply only to specific narrow situations (for example, a $10,000 withdrawal allowed for a first home purchase) and so are not helpful to the many individuals who are just short of money but don't fit any of the precise exceptions.
However, there is one penalty exception that can be used by every IRA owner: the SOSEPP. With the help of an accountant or planner to do the math, the IRA owner sets up a series of monthly, quarterly, or annual payments from the IRA (or from part of the IRA moved to a separate new IRA set up just for this purpose). The IRA owner then must take these periodic payments (and no more and no less!) regularly until reaching age 59.5 (or for at least five years, if that would be a longer period).
The IRS has provided safe harbors regarding how these "equal payments" can be calculated. The concept of the IRS safe harbors is that the series payments would exhaust the IRA balance at the end of the taxpayer's life expectancy if it continued that long. Within that framework, the IRS offers a few methods of structuring the series: One is analogous to a life annuity ("annuitization"); one is like a loan amortization schedule ("amortization"); and one is computed the same way as required minimum distributions, except starting at this individual's young age instead of age 72.
Annuity- and amortization-method payouts assume that a certain growth rate will accrue on the IRA's investments over the applicable life expectancy, so these methods will provide larger payments, at least in the beginning of the SOSEPP. The RMD method does not assume any future investment growth, so payouts will increase over the years if there is investment growth (or decrease if the account loses money).
Within each option are myriad additional choices regarding whether to use a single life-type payout or a joint life expectancy payout based on the ages of the IRA owner and the designated beneficiary, and whether to annually recalculate the IRA balance.
Though the different methods of structuring the SOSEPP provide considerable flexibility, there have always been two firm boundaries to the IRS' safe harbor: life expectancy and interest rate. Life expectancies must be based on the IRS' actuarial tables used to calculate RMDs (modified as needed to accommodate younger ages); and the interest rate used to establish annuity or amortization payouts could not exceed "120% of the federal midterm rate (determined in accordance with section 1274(d) for either of the two months immediately preceding the month in which the distribution begins)." All this was dictated back in 2002: See Rev. Rul. 2002 62, 2002 2 CB 710. While the IRS-promulgated methods are not a requirement of a valid SOSEPP, few planners step outside the safe harbors of Rev. Rul. 2002-62 and its successors.
(Caution: Setting up an IRA SOSEPP is a complex undertaking, with substantial penalties possible if a mistake is made in structuring the SOSEPP or if the SOSEPP is in any way "modified" after it begins. These details (and planning suggestions) are not covered in this article, which focuses solely on the impact of the changes made in the recent IRS Notice 2022-6. To learn more about SOSEPP requirements and techniques, see "Where to Read More" at the end of this article.)
Gradually a problem arose: Most people using a SOSEPP to withdraw IRA money prior to age 59.5 do so because they need some cash fast, and their IRA is their only resource. But with interest rates approaching zero in recent years, the annuity and amortization methods produced correspondingly smaller payments--not at all what the average SOSEPP-seeker wants.
Effective in 2022, the IRS initiated new life expectancy tables for RMDs, as explained in my January 2022 column. But that actuarial update did not cover SOSEPPs; it applied only to RMDs. Now the IRS has completed the circle by also updating the life expectancy tables for safe-harbor SOSEPPs, in Notice 2022-6.
Since a person starting a SOSEPP using the new 2022 tables will have a longer life expectancy than under the old tables, SOSEPP payments will be a bit lower than they would have been under the 2002 tables. Though this is an unwelcome result for the average SOSEPP client, the effect is relatively minor: Adding a year or two to the life expectancy of someone younger than age 59.5 makes only a small difference for a lifetime payout based on that young person's life expectancy.
But the IRS also made another change in Notice 2022-6: It increased the maximum permitted interest rate for new and future SOSEPPs. For any SOSEPP beginning in 2022 or later, the maximum interest rate that may be used to compute an annuity- or amortization-method SOSEPP will be the greater of the old 120% of the federal midterm rate or 5%. The effect of increasing the assumed growth rate from approximately 1.5% (the current "120% of the federal midterm rate") to 5.0% produces a dramatic increase in annuity- or amortization-method payments over the long life expectancy of someone younger than 59 and a half.
Example: Les Cash, who turned age 54 in January 2022, is in a tough place. He's behind on his car payments, mortgage, and credit card bills. He wants to tap his $400,000 IRA to close his cash gap. Since he's between jobs right now, the income tax on any withdrawal would be manageable, but the 10% "additional tax" would be most unwelcome. Working with his accountant he looks at his SOSEPP options. Like most SOSEPP seekers, he is looking for the SOSEPP structure that would give him the most cash the soonest. The simplest route to that result is to use the amortization method with a single life expectancy and an annual payout.
Here are the results Les would get with that structure using the pre-2022 guidance and then using the post-2021 methods promulgated in Notice 2022-6:
Old Rules: The single life table under the pre-2022 IRS life expectancy tables provided a life expectancy of 30.5 years for someone age 54. The maximum SOSEPP rate for January 2022 under the old rules would have been 1.57%. Using those numbers, an amortization-method SOSEPP for Les, liquidating a $400,000 IRA, would produce annual payments of about $16,000.
New Rule: The new life expectancy table gives him a longer life expectancy at age 54--32.5 years instead of 30.5. That change would produce smaller payments. But it also permits him to up the projected interest rate to 5%, which produces substantially larger payments under his preferred amortization-method SOSEPP--around $24,000 a year instead of around $16,000.
Clearly, Les will want to use the new 5% maximum interest rate because it gives him a much larger annual payout.
(Note:Why use approximate numbers rather than exact ones for these examples? Because there are different results when the annual payouts are computed using end-of-year versus beginning-of-year payment dates for an annual-payment SOSEPP. Though the IRS pronouncements use end-of-year assumptions in their examples, that does not usually make sense for a SOSEPP, which starts payments as soon as possible--that is, at the beginning of each payout year rather than the end. So my numbers guy tells me!)
Nobody wants to encourage people to spend their retirement accounts prior to retirement. But many individuals find themselves (like Les Cash) either with no other option or (in some cases) better investment and financial planning options by shifting money from their IRA to a taxable account, whether to spend it (like Les Cash) or to make other investments better suited to the taxable account. The SOSEPP is an important safety valve for those who need it and a useful planning device for the fortunate few with "too large" IRAs. So, it is good news that safe-harbor SOSEPP options have been updated as to both interest rates and life expectancy.
But Notice 2022-6 leaves some questions unanswered regarding transition to the new safe-harbor guidelines. The guidance provided by Notice 2022-6 is effective in a phased-in manner. For safe-harbor treatment, the new life expectancy tables must be used for SOSEPPs starting in 2023 or later: "Earlier guidance is replaced for any series of payments starting on or after Jan. 1, 2023 ..." But for SOSEPPs starting in 2022, the Notice tells us that "... new guidance may be used for series of payment starting in 2022." (Emphasis added.)
So, a SOSEPP starting in 2022 can be in the safe harbor by using the old life expectancy tables plus the old interest rate, or the new tables and the new rate. Can an annuitization- or amortization-type SOSEPP initiated in 2022 combine the old life expectancy table with the new maximum interest rate? That would provide slightly larger payments than using both new life expectancy and new interest rate.
Other up-in-the-air questions deal with SOSEPPs started before 2022. Notice 2022-6 tells us that a SOSEPP started before 2022 that is using the RMD method can switch to the new life expectancy tables. Can that switch be made anytime, or only in 2022-23? Also, since a pre-2022 SOSEPP that is not currently using the RMD method can (under existing guidance) switch to the RMD method at any time, would a post-2022 switch to the RMD method entitle the switcher to use either the old or new table?
Since Notice 2002-6 is merely an extension of the IRS' safe-harbor guidance and does not purport to impose absolute limits on how SOSEPPs can be structured, presumably any reasonable interpretation of the transition rule will be acceptable. Whatever guidance (if any) the IRS eventually offers on those questions, one thing is clear: An annuity or amortization SOSEPP set in motion (that is, under which the equal payments have already started) prior to this Notice cannot switch to the new higher interest rate. That option is reserved only for SOSEPPs that incorporate the new guidance in their initial design.
For the IRS guidance on new life expectancy tables and safe-harbor maximum interest rate for SOSEPPs, see IRS Notice 2022-6, 2022 5 IRB 460 (01/18/2022). For detailed explanation of the SOSEPP exception to the 10% penalty, including planning tips and compliance pitfalls, see ¶ 9.2 and ¶ 9.3 (pages 582-604) of Natalie Choate's book Life and Death Planning for Retirement Benefits (8th ed. 2019).
Natalie Choate is a lawyer in Wellesley, Massachusetts, who concentrates in estate planning for retirement benefits. The 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article do not necessarily reflect the views of Morningstar.