Retiring Early? Avoid The Early Penalty Tax

If you weren’t among that group that retired early, it’s good to remain working for a bit longer if you can for two main reasons: (1) working one extra year is like saving 2 percent of your salary for 30 years; and (2) if you actually need to retire early and take distributions from your retirement accounts (like a 401(k) or IRA), you could be subject to a 10% penalty tax for withdrawals prior to age 59.5.

But if you are dead set on retiring early, the good news is there are some exceptions to the 10% early withdrawal penalty tax. In this article, we’re going to focus on one big exception: the substantially equal periodic payment (SEPP) exception. We’re going to look at the details of SEPP and the impact of one recent IRS change that will allow those retiring before pre-59½ to tap into more of their money without penalty.

The Basics of Exceptions Explained

When most people think of IRS rule 72(t), they likely think of the 10% early withdrawal penalty that’s included in this rule. But also in this rule are a myriad of exceptions to this penalty tax. So think of somebody who’s 45 and wants to withdraw $100,000 from their IRA to buy a boat. That person will get a 10% penalty tax on the taxable income from the distribution.

The whole purpose of this penalty tax is to discourage people taking out money from their retirement accounts before retirement. The reason the government and the IRS gave us special tax benefits – like tax deferral, tax deductions and tax-free growth – is that they want us to fund the time period where we’re no longer working so we’re not solely dependent on government benefits.

If you recall, the government was only one leg on the three-legged stool that we considered our retirement funding – employer savings and our own savings being the other two legs. These three legs are what’s considered to provide stability in retirement.

So the tax deferrals, tax deductions and tax-free growth are the government’s carrots, whereas the penalties for early withdrawals are the sticks to discourage taking money out too early and jeopardizing retirement. Honestly, while you might not like the penalty tax if you get hit with it, you could also argue that making the penalty higher, say 25%, would be more effective.

But the government also realizes that sometimes people actually need the money from their retirement savings to get by in times of turmoil. As such, they don’t want to make it so onerous that there’s no way to get the money out of these retirement accounts. In response, a bunch of exceptions were put in place to alleviate this penalty tax. Here are some exceptions :

  • After you hit age 59½
  • Death
  • Disability
  • First-time home buying up to $10,000 (IRAs)
  • Certain unreimbursed medical expenses
  • Substantially equal periodic payments (SEPP)

While these are general basics, it’s always a good idea to visit the IRS site on 72(t) exceptions to dive into more specifics about what exceptions there are for qualified retirement accounts like 401(k)s versus IRAs.

A Focus on SEPP

We might need multiple distributions from our qualified accounts before age 59½ when we don’t qualify for any other exceptions (for example, we didn’t die or we didn’t become disabled). So how are we going to get this money if we voluntarily retire early or get forced out of our job?

One option might be the substantially equal periodic payment (SEPP) exception. which is exactly what it sounds like: it’s taking a stream of equal payments over a period of time, which are exempt from the 10% penalty tax. Think of it as annuitizing a portion of your retirement accounts. This exemption only applies to IRAs.

There were roughly 3 million people who decided to retire, or were forced into early retirement, during the pandemic who now might need their retirement savings. However, the general rule is if this person just pulls the money out of those retirement accounts before they reach age 59½, they’re going to get slapped with a 10% penalty tax. If that person was 50, that’s 10 percent a year for basically a decade, or in essence, an entire year of distributions in penalty taxes.

Using the SEPP exception could be the right decision to avoid this 10 percent penalty tax. The SEPP rules are pretty strict, so you need to know the rules before you go down this route. Essentially once you start a SEPP from an IRA, you’ve got to follow through the time period that the code section defines, which is the longer of five years or until you reach age 59½. So, if you start this at age 57, you have to run it for five years until you turn 62, even though you reached and surpassed age 59½. If you start it at age 58, you have to run it until age 63, and so on.

On the flip side, if you start at age 50, you have to go through age 59½, meaning you’ll have 10 years of substantially equal periodic payments before you can turn this valve back off.

If you decide you want to turn the valve off earlier, you’ll be subject to taxes for all the previous years of payments. For example, if you decide to retire at age 50 and decide at age 55 you want to go back to work, you’ll owe taxes on those five years of payments. So if you took out $100,000 over five years, you’d owe $10,000 (10% penalty), plus the interest you’d owe on the back taxes ($500 to $1,000), you might end up owing somewhere near $11,000. There are also only a few ways to modify the payments once they have started.

Determining SEPP

There are only three different methods allowed to determine what is a substantially equal periodic payment: the required minimum distribution method, the fixed amortization method and the fixed annuitization amount.

With the RMD method, just think of normal required minimum distributions where you take the account balance of the previous year and divide it by your life expectancy. Because the person will be pre-59½, they have a long life expectancy and therefore smaller distributions. This approach will typically provide the smallest amount of money, so if the goal is to access a little bit of money but minimize depleting the IRA, it can be the best SEPP approach.

The other two methods, whether it’s fixed amortization or fixed annuitization, provide similar, but not identical outcomes. These two methods are top of mind right now because the IRS recently put out a notice saying they were moving the interest rate up from 1.6% (or 120% of the federal midterm rate, whichever is larger) up to 5%. This substantial change kicked in February 2022 and only impacts both the fixed annuitization and the fixed amortization methods. It doesn’t impact the RMD approach because for that we’re using the updated RMD tables which came out now in 2022. What it really does is allow a lot more money to be paid out each year under the SEPP and avoid the penalty tax.

An Example

Before we dive into the example, note that with SEPP, you essentially do it from a single IRA – you don’t have to aggregate all your IRAs. However, the IRA that you do use, you have to essentially wall it off, meaning no more money can come in or go out. If you put more contributions into that IRA, it will actually disqualify the substantially equal periodic payments.

Here is an example of how much more people could take under SEPP with the 5% change. These are rough estimates:

Let’s take a fictional character Stephanie, who’s 50 and has $500,000 in an IRA. She has other qualified plan assets, but for SEPP will use just that one IRA. With the old interest rate, 1.6%, under the fixed amortization method today, roughly $19,097 per year would need to be distributed over 10 years to meet SEPP exemption from 72(t) to not have to pay the 10% penalty on the $20,000 that Stephanie might be withdrawing that year.

Stephanie might say that $20,000 is too much and that she needs less money. In this case she could use the RMD approach using the new Lifetime Factor table that started in 2022, she’d use 48.5 at age 50, and the amount would be $10,309 ($500,000/48.5).

Regardless of the approach, both would be subject to ordinary income taxes, but not the 10% early withdrawal penalty tax.

Now, let’s just change the one factor that changed with this IRS notice – the 5% instead of 1.6%. The fixed amortization method withdrawal would now be $30,807. The RMD approach, since it depends on the Lifetime Factor table, does not change. So if you want the lesser amount, you can go with the RMD method.

Note that if you deplete the IRA, that ends the substantially equal periodic payments. You’re not going to have to make them up or pay back taxes from somewhere else.

Things to Keep in Mind With SEPP

To reiterate some important points: make sure you wall off the account you are using for SEPP. Once you go down this road, you cannot turn off SEPP once they’ve started or you’ll owe penalties and back taxes and interest on the payments.

Also, you want to ensure you have the right distribution amount in the account you’ll be using for SEPP. Ensure you separate that account and fund it properly prior to SEPP. So if that means rolling over from a 401(k) to the IRA, then you’ll need to do that in the beginning. You can talk to your financial professional and be intentional about this because some of the aggregation rules can cause complexity.

Another important point is the IRS code allows for a one-time change from the fixed approaches to the RMD approach but not the other way around. Why would you want to do this? Let’s go back to our example, Stephanie. Say she starts off under one of the fixed methods today, which generally result in similar payments. She’s rolling along taking out $30,000 a year from age 50 to 55. Then somebody offers her a fantastic job, luring her to come back to work. Now she’s earning one of the biggest paychecks she’s ever earned in her life and she has this additional $30,000 on top of it. If she continues down this route, over the next five years, she’ll take $150,000 of distributions from her tax-deferred IRA.

At this point, she has three choices: continue the payments and take out $150,000 from the IRA; turn it off and pay back taxes on $150,000, plus interest; or switch to the RMD approach for the remaining five years, which will be closer to around $11,000 a year.

The last thing to keep in mind is there is the ability to do SEPP as yearly, monthly or even daily payments (though this last option would be a total pain). But that’s something you need to set at the beginning. There has been some discussion about how changing from monthly to yearly or vice versa could be considered a modification of the SEPP, so to be safe you want to ensure that whatever you set at the beginning, you stick to it.

Connecting With Your Professional

If you’re retiring early, congratulations! That’s a huge milestone. But you’ll want to navigate this transition proactively and with care. It’s always a good idea to work with a financial professional who can help you do that in the most efficient and effective way possible.

By Jamie Hopkins, Contributor

© 2022 Forbes Media LLC. All Rights Reserved

This Forbes article was legally licensed through AdvisorStream.

Theodore Spinardi, CFP®

Founder & Senior Managing Director

Summit Wealth Group

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Meet Kate

Kate graduated from Oral Roberts University with a degree in Global Ministry and the Marketplace and went directly into full-time Ministry at her local church following graduation.


With a passion for helping people win and stewarding an atmosphere of excellence, she is driven to elevate systems, procedures, and programs. As a lifelong Tulsa resident, Kate recently married her high school sweetheart in July of 2022. When Kate is not in the office, you will find her serving the local church, playing pickleball, enjoying coffee with friends, and cheering on her husband, Brody, at the golf course.