Distribution Rules for SEP IRAs

When I crossed over from W-2 employee to being self-employed and co-founded our investment firm, I was excited about the plethora of business retirement plans that I now had at my disposal.

One such option (which ended up being the one I went with) is the Simplified Employee Pension (SEP) IRA. A SEP IRA and traditional IRA is the contribution limits imposed. In 2010, the contribution rules for the SEP are allowable for the lesser of either 25% of your self-employment net earnings; or $49,000.

The other similarity between an SEP IRA and a traditional IRA is the distribution rules. The distribution of both the IRA account and SEP IRA must be taken at some point but some distributions are elective and others will be forced. Penalties and taxes that are applied to both distributions will be dependent on the age of owner at the time of distribution as well as the tax deductions of the assets during the contribution time.

Before the age of 59 ½, any early withdrawal will be subjected to a 10% penalty. This is in addition to federal income tax imposed. There are some exceptions for deferral of the 10% early withdrawal penalty including:

Money Used for Medical Expenses

If withdrawal is made to pay un-reimbursable medical costs, any amount going over 7.5% of the adjusted gross income of the individual for the year will not incur the early withdrawal penalty.

Money Used to Pay Medical Insurance

A penalty-free distribution can be used to pay medical insurance for the individual, their spouse, and any dependents as long as the distribution is necessary due to:

Job loss

Unemployment benefits have been paid by state or federal agencies for 12 consecutive weeks.

The person receiving distributions during the year they receive unemployment compensation or for the next year.

The person receives distributions no later than 60 days after reemployment occurs.

Money Used for a Disability

When an individual becomes disabled before the age of 59 ½ and takes a distribution from their IRA account, the distribution does not incur a penalty. Proof of the disability from a licensed medical provider must be shown that either a mental or physical condition prevents the individual from finding gainful employment.

Money Used to Purchase a First Home

Monies can be withdrawn penalty-free if the funds are used to purchase, build, or remodel a first home for the account holder, their spouse, child, grandchild, or a parent of the account holder. The monies must be used to pay eligible acquisition costs before the end of the 120th day of receiving the distribution of funds. The monies withdrawn for a first home purchase can not be more than $10,000 during the account owner’s lifetime for single individuals. Married couples can withdraw a lifetime total of $20,000.

Money Used for Tax Levy

Monies in an IRA account can be levied by the IRS if taxes are owned which result in a distribution amount. Any distribution amounts will no incur a penalty fee.

Money Used for Educational Expenses

If monies are being used to fund the expenses of higher education of the owner or the dependents of the owner, the amounts will be penalty free. Education expenses that are eligible include tuition, books, supplies, and school fees as part of a requirement for enrollment in a eligible college, university, vocational school, and other post-secondary school participating in student aid programs through the Department of Education.

Beneficiary Distributions

For the SEP program, penalty-free distributions are made from a series of equal payments and must last five years or until the owner reaches the age of 59 ½, whichever time period is longer.

For IRA beneficiaries, if the owner of the account dies before having reached age 59 ½, the distribution amounts for the beneficiary are not penalized.

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