Edition

IRS Updates Guidance on SEPP Exception to 10% Additional Tax

By Mark E. Griffin and Prasanthi S. Paritala

TAXING TIMES, October 2022

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On Jan. 18, 2022, the IRS released Notice 2022-6, 2022-5 I.R.B. 460, to provide guidance on whether distributions from an individual account under a qualified retirement plan fall under the exception to the 10 percent additional tax under section 72(t) of the Internal Revenue Code (Code) for substantially equal periodic payments (SEPPs). The Notice updates previous guidance under Rev. Rul. 2002-62, 2002-2 C.B. 710, to address the updated life expectancy tables that were part of final regulations under Code section 401(a)(9). The Notice also modifies and supersedes this previous guidance and the guidance in Notice 2014-5, 2014-1 C.B. 526, on satisfying the similar exception to the 10 percent additional tax for SEPPs under Code section 72(q) for non-qualified annuity contracts.  

Background

Code sections 72(q)(1) and 72(t)(1) provide for a 10 percent additional tax on early distributions from non-qualified annuities and qualified retirement plans (including IRAs), respectively. Code sections 72(q)(2)(D) and 72(t)(2)(A)(iv) each provide an exception to the additional tax for distributions that are “part of a series of substantially equal periodic payments” made not less frequently than annually for the life (or life expectancy) of the taxpayer or employee, as applicable, or the joint lives (or joint life expectancies) of such taxpayer or employee and his designated beneficiary” (“SEPP exception”). For purposes of the SEPP exception under Code section 72(t)(2)(A)(iv), an “employee” includes an IRA owner. Under Code sections 72(q)(3) and 72(t)(4), if SEPPs commence and are subsequently modified (other than by reason of death or disability) before the employee turns 59 ½ or within five years of the first payment, then the 10 percent additional tax that was previously avoided under the SEPP Exception is imposed, or recaptured, plus interest for the deferral period, in the year of the modification.

Rev. Rul. 2002-62, 2002-42 I.R.B. 710, modified earlier guidance in Notice 89-25, 1989-1 C.B. 662, Q&A-12, which provided that payments were considered to fall under the SEPP exception in Code section 72(t)(2)(A)(iv) if they were calculated in accordance with one of three safe harbor methods: (1) the required minimum distribution (RMD) method, (2) the fixed amortization method, or (3) the fixed annuitization method.

  1. RMD method—Payments were treated as SEPPs if the annual payment was determined “using a method that would be acceptable for purposes of calculating the minimum distribution required under section 401(a)(9).” Distributions were calculated each year by dividing an “account balance” for that year by a life expectancy factor for that year. The Notice specified that the payment may be determined based on the life expectancy of the employee or the joint life and last survivor expectancy of the employee and beneficiary.
  2. Fixed amortization method—Payments were treated as SEPPs if the amount to be distributed annually was determined by amortizing the taxpayer’s account balance over a number of years based on a life expectancy factor and an assumed interest rate.
  3. Fixed annuitization method—Payments were treated as SEPPs if the amount to be distributed annually was determined by dividing the taxpayer's account balance by an annuity factor based on a specified mortality table and an assumed interest rate.

In Rev. Rul. 2002-62, 2002-42 I.R.B. 710, the IRS modified its earlier guidance in Notice 89-25. The ruling also replaced the guidance in Notice 89-25 for any series of payments commencing on or after January 1, 2003, and was optional for distributions commencing in 2002. The ruling generally retained the three safe harbor methods for calculating SEPPs and it provided more guidance on the various assumptions used in the three methods (i.e., the life expectancy tables, interest rate, and account balance).  

  • Life expectancy table—The ruling specified that the life expectancy tables that can be used to determine distribution periods included (1) the uniform lifetime table in Appendix A of the ruling, (2) the single life expectancy table in Treas. Reg. section 1.401(a)(9)-9, Q&A-1, or (3) the joint and last survivor table in Treas. Reg. section 1.401(a)(9)-9, Q&A-3.
  • Interest rate—The ruling also modified the allowable interest rate and stated that the interest rate that may be used for purposes of the fixed amortization method or fixed annuitization method was any interest rate that is not more than 120 percent of the federal mid-term rate (determined in accordance with Code section 1274(d) for either of the two months immediately preceding the month in which the distribution begins).
  • Account balance—The account balance used to determine SEPP payments must be determined “in a reasonable manner based on the facts and circumstances.” The ruling provided, as an example, that for an IRA with daily valuations, it was reasonable to determine the account balance based on the value of the IRA on any date during the period from the end of the year before the first distribution and the date the first distribution is made. Under any of the three safe harbor methods, certain changes in the account balance were considered to be a modification to the SEPPs, thus triggering the recapture of the 10 percent additional tax. These changes included “(i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.”

Rev. Rul. 2002-62 also explained that under the RMD method, the account balance, the number from the chosen life expectancy table, and the resulting annual payments were redetermined for each year. A change in the payment amount from year to year under the RMD method would not be deemed a modification to the SEPPs that would trigger the recapture of the 10 percent additional tax as long as there was not a change to another method of calculating the payments. Under the fixed amortization method, the account balance, the number from the chosen life expectancy table and the resulting annual payment were determined once for the first distribution year, and the annual payment is the same amount in each succeeding year. Similarly, under the fixed annuitization method, the account balance, the annuity factor, the chosen interest rate, and the resulting annual payment were determined once for the first distribution year, and the annual payment was the same amount in each succeeding year. 

In Notice 2004-15, 2004-9 I.R.B. 526, the IRS extended the guidance in Notice 89-25, as modified by Rev. Rul. 2002-62, to the SEPP exception for non-qualified annuities under Code section 72(q)(2)(A)(IV), clarifying that use of one of the three safe harbor methods described in Notice 89-25 also would satisfy the SEPP exception under this section with respect to a distribution from a non-qualified annuity. In issuing this guidance, the IRS noted that Code sections 72(t) and 72(q) were enacted for the same purpose, and therefore it was appropriate to apply the same methods to determine whether a distribution meets the SEPP exception under either section.

In November 2020, the Treasury Department and IRS released final regulations under Code section 401(a)(9) updating the RMD life expectancy tables with respect to “distribution calendar years” beginning on or after Jan. 1, 2022. See T.D. 9930, 85 Fed. Reg. 72472 (Nov. 12, 2020). As part of the final regulations the IRS noted that it expected to issue supplemental guidance to update Rev. Rul. 2002-62.

Notice 2022-6

Notice 2022-6 updates the previous guidance in Rev. Rul. 2002-62 in order to conform that guidance to the updated life expectancy tables. Notice 2022-6 generally permits the same three safe harbor methods of calculating SEPPs that were set forth in prior guidance, but it makes several notable changes.

  • Life Expectancy Tables—Notice 2022-6 allows any of the following life expectancy tables for purposes of calculating SEPPs under the RMD method and the fixed amortization method (because the fixed annuitization method uses the mortality table on which the RMD life expectancy tables are based, the life expectancy tables are not relevant to the fixed annuitization method):
    • The Uniform Lifetime Table that is set forth in Notice 2022-6. This is the same as the new Uniform Lifetime Table in Treas. Reg. section 1.401(a)(9)-9(c) for RMDs that are required for 2022 or later, except that the version included in the Notice starts at age 10 rather than age 72.
    • The Single Life Table in Treas. Reg. section 1.401(a)(9)-9(b) for RMDs that are required for 2022 or later.
    • The Joint and Last Survivor Table in Treas. Reg. section 1.401(a)(9)-9(d) for RMDs that are required for 2022 or later. The Notice clarifies prior guidance by stating that this table may be used “even if the designated beneficiary is not the spouse.” 

For purposes of the fixed annuitization method for calculating SEPPs, the Notice states that the annuity factor is derived using the mortality table in Treas. Reg. section 1. 401(a)(9)-9(e), on which the updated RMD life expectancy tables are based.   

  • Interest rate—The Notice also modifies the interest rate assumptions that must be used under the fixed amortization and fixed annuitization methods. It states that the applicable rate is any interest rate that is not more than the greater of (1) 5 percent or (2) 120 percent of the federal mid-term rate determined in a particular manner.
  • Account balance—With respect to the fixed amortization and fixed annuitization methods, Notice 2022-6 retains the rule from Rev. Rul. 2002-62 that the account balance must be determined “in a reasonable manner based on the facts and circumstances.” This standard will be satisfied if the account balance is determined “on any date within the period that begins on December 31 of the year prior to the date of the first distribution and ends on the date of the first distribution.” However, with respect to the RMD method, the Notice departs from previous guidance, which applied the “reasonable manner” standard. Instead, for purposes of the RMD method for calculating SEPPs, the account balance is determined under Treas. Reg. section 1.401(a)(9)-5, which sets forth specific valuation date requirements for RMD purposes. For employer plans, the regulation generally requires use of the account balance as of the last valuation date in the prior calendar year, with certain adjustments described in the regulation. For IRAs, the regulations state that the prior year-end account balance may be used instead, with certain (but different) adjustments. The Notice retains the rule from the prior guidance that a modification of SEPPs will occur (thus triggering the recapture tax) if, after the date SEPPs are first determined, certain changes occur in the account balance. One of the enumerated changes is “any transfer of a portion of the account balance to another retirement plan.” This deviates slightly from prior guidance, which referred to any “nontaxable transfer,” but the reason behind this deviation is not clear.

    Regarding the requirement that the account balance for purposes of the RMD method must be determined under Treas. Reg. section 1.401(a)(9)-5, the existing final RMD regulations and recently proposed RMD regulations each provide that RMDs with respect to an annuity contract that has not been annuitized is determined under Treas. Reg. section 1.401(a)(9)-5, and that for such purposes the account balance generally equals the dollar amount credited under the contract “plus the actuarial present value of any additional benefits ([such as] survivor benefits in excess of the dollar amount credited to the employee or beneficiary) that will be provided under the contract.” Treas. Reg. section 1.401(a)(9)-6, Q&A-12; Prop. Treas. Reg. section 1.401(a)(9)-6(m)(2). Thus, the actuarial present value requirement seemingly would apply in determining the “account balance” of a deferred annuity for purposes of calculating SEPPs under Notice 2022-6. This was less clear under the prior guidance, because the standard was based on reasonableness rather than a cross-reference to the specific rules that govern account balance determinations under the RMD regulations.

Notice 2022-6 extends these rules to the SEPP exception under Code section 72(q)(2)(D). Note, however, that none of the earlier guidance or Notice 2022-6 addresses when amounts paid in the form of an annuity satisfy the SEPP exception. For example, there is no guidance with respect to variable annuity payments or annuity payments that are increased by a constant percentage annually.

Notice 2022-6 replaces the guidance in Rev. Rul. 2002-62 and Notice 2004-15 for any series of payments commencing in or after 2023. Taxpayers may continue to rely on Rev. Rul. 2002-62 with respect to payments commencing in 2022, but they may choose to rely on Notice 2022-6 for those payments. In addition, for payments that commence before 2023 using the RMD method and based on the Rev. Rul. 2022-62 life expectancy tables, if a taxpayer later substitutes the new version of the applicable table for the old version of that table, the substitution will not be treated as a modification of the payments for purposes of the recapture tax.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.

Mark E. Griffin is a partner with Davis & Harman LLP. He can be reached at megriffin@davis-harman.com.

Prasanthi S. Paritala is an associate with Davis and Harman LLP. She can be reached at psparitala@davis-harman.com.