Traditional IRA distributions are taxable at ordinary income tax rates when distributed, either to the owner or beneficiaries. Setting up an IRA to pay out using the Substantially Equal Periodic Payment (SEPP) is an effective way to begin early withdrawals without unnecessary tax.

If IRA account assets are withdrawn prior to age 59 ½, not only will the owner pay ordinary income taxes on the withdrawal but also a 10% excise tax penalty. Section 72(t) of the Internal Revenue Code allows the plan owner to withdraw funds from a retirement account without the 10% penalty if the withdrawals are a series of substantially equal periodic payments.

Once the owner begins taking distributions as part of a SEPP, the payments must continue for the longer of five years or to age 59 ½. For example, a 53-year-old IRA owner must take distributions for five and a half years until age 59 ½, whereas a 56-year-old owner is only required to take distributions for five years to age 61.

The amount you can withdraw is a function of the account balance and one of three calculation rates allowed by the IRA. Each results in a different allowed withdrawal amount, making it possible to tailor the distribution to meet your specific need.

The amortization method is determined by using the life expectancy of the taxpayer and his or her beneficiary, and a chosen interest rate. This interest rate cannot exceed 120% of the federal mid-term rate, which for January 2005 was set at 4.53%.

The annuitization method is similar to the amortization method; however the amount is determined by using an annuity based on the taxpayer’s age, age of beneficiary and chosen interest rate.

The required minimum distribution (RMD) method calculates an annual payout by dividing the account balance for that year by the life expectancy factor of the taxpayer and beneficiary. Using this method, the amount to be paid will be recalculated each year.

To see how this works, let’s consider John Smith, age 53, wife age 52, who has a $250,000 IRA he wishes to tap for early retirement income. His IRA investment return is 6% annualized. He plans to continue the withdrawals for 8 years, and then tap other retirement accounts, leaving this IRA to accumulate. Using joint life expectancy and an interest rate of 4.53%, his withdrawal amounts would be as follows:

• Amortization Method: Annual payment of $13,908 and account balance at the end of 8 years of $260,809
• Annuitization Method: Annual payment of $14,942 and account balance at the end of 8 years of $250,573
• RMD Method: Annual payment beginning at $6,579 and a balance in 8 years of $315,441.

John’s choice of withdrawal calculation will be based upon his need for income and his plans for his IRA once his required payment to age 59 ½ has been met. He can change his distribution type one time without penalty from the Annuitized or Amortized methods to the Life Expectancy (RMD) method if he feels the fixed amount would prematurely deplete his account.

Other rules that must be followed to avoid the imposition of the 10% penalty tax include the prohibition of withdrawing additional sums, or making transfers from this account. The owner may transfer the full amount without penalty to another custodian or trustee as long as the payments continue. Finally, additional contributions may not be added to the account balance while part of a SEPP plan.