Distribution Rules

Understanding retirement account distribution rules is essential for CFP professionals. Withdrawals from qualified retirement plans and IRAs are subject to complex rules regarding taxation, penalties, and timing. This section covers the 10% early withdrawal penalty and its exceptions, substantially equal periodic payments (SEPP), Roth distribution ordering, QDRO distributions, and Net Unrealized Appreciation (NUA) strategies.

The 10% Early Withdrawal Penalty

Distributions from qualified retirement plans and IRAs taken before age 59.5 are generally subject to a 10% early withdrawal penalty under IRC Section 72(t), in addition to ordinary income tax. The penalty is designed to discourage using retirement funds for non-retirement purposes.

SIMPLE IRA Special Rule: Distributions from a SIMPLE IRA within the first two years of participation incur a 25% penalty instead of 10%.

Penalty Exceptions by Account Type

The IRS provides numerous exceptions to the 10% penalty, but they apply differently depending on whether funds come from a qualified plan or an IRA.

Exceptions for BOTH Qualified Plans and IRAs

Qualified Plan ONLY Exceptions

IRA ONLY Exceptions

Key Distinction for Exam: The separation from service at age 55+ exception applies ONLY to qualified plans—if funds are rolled to an IRA, this exception is lost. The home purchase and education exceptions apply ONLY to IRAs.

Substantially Equal Periodic Payments (SEPP) - Section 72(t)

SEPP plans allow penalty-free distributions before age 59.5 if payments are calculated using an IRS-approved method and continue for the required period.

SEPP Requirements

1. Payment frequency: At least annually (monthly or quarterly permitted if consistent)
2. Duration: Continue for the longer of:
   • Five full years, OR
   • Until you reach age 59.5
3. Separation from service: For qualified plans, SEPP is only available AFTER separation from the employer
4. IRA availability: Can begin SEPP from an IRA at any time, even while employed

Three IRS-Approved Calculation Methods

Reasonable interest rate: Generally 120% of the federal mid-term rate (as published monthly by the IRS).

SEPP Modification Penalty

Critical Rule: If you modify or stop SEPP payments before completing the required period, you owe:

• 10% penalty on ALL prior distributions (retroactive to year one)
• Interest on the unpaid penalties from the original due dates

Modifications include:

• Changing calculation method (except one-time switch from amortization/annuitization to RMD method)
• Stopping payments
• Taking more or less than the calculated amount
• Rolling over or converting accounts subject to SEPP

Roth IRA Distribution Ordering Rules

Roth IRA distributions follow a specific ordering rule that determines which funds come out first and their tax/penalty treatment.

The Ordering Sequence

Key Rules for Each Category

Contributions:

• Always come out first
• Always tax-free (already taxed when contributed)
• Always penalty-free regardless of age or holding period

Conversions:

• Come out in chronological order (oldest conversions first)
• Tax-free (taxes already paid at conversion)
• Subject to 10% penalty if distributed within 5 years of that specific conversion AND before age 59.5
• Each conversion has its OWN 5-year clock

Earnings:

• Come out last
• Tax-free only if "qualified distribution"
• Penalty-free only if qualified or exception applies

Qualified Distribution Requirements

A Roth IRA distribution of earnings is qualified (tax-free AND penalty-free) if:

1. The 5-year holding period has been satisfied (from January 1 of the year of the first contribution or conversion), AND
2. One of these triggering events occurs:
   • Age 59.5+
   • Death
   • Disability
   • First-time home purchase (up to $10,000)

QDRO Distributions

A Qualified Domestic Relations Order (QDRO) is a court order that gives an alternate payee (typically a spouse or former spouse) the right to receive all or part of a participant's benefits in a qualified retirement plan.

Key QDRO Rules

Exam Tip: The QDRO exception to the 10% penalty applies ONLY to qualified plans. If the alternate payee rolls the QDRO distribution to an IRA and later takes a distribution before 59.5, the 10% penalty would apply (unless another exception is met).

Net Unrealized Appreciation (NUA)

Net Unrealized Appreciation (NUA) is a tax strategy for employer stock held in qualified retirement plans (401(k), ESOP, stock bonus plans). It allows the appreciation on employer stock to be taxed at long-term capital gains rates rather than ordinary income rates.

How NUA Works

NUA Requirements

1. Lump-sum distribution: Entire balance of all similar qualified plans must be distributed within one tax year
2. Triggering event: Must occur due to:
   • Separation from service
   • Attaining age 59.5
   • Death
   • Disability
3. In-kind distribution: Stock must be distributed directly to taxable brokerage account (NOT rolled to IRA)
4. Employer securities: Only applies to stock of the employer sponsoring the plan

NUA Calculation Example

Tax at distribution: $20,000 taxed as ordinary income Tax when sold: $80,000 taxed at long-term capital gains rate (regardless of holding period after distribution)

When NUA is Most Beneficial

• Large difference between cost basis and current FMV
• Taxpayer in high ordinary income bracket
• Long holding period in plan (more appreciation)
• Immediate liquidity need (can sell stock right away with favorable LTCG treatment)

NUA vs. Rollover Decision

On the CFP Exam

Expect questions testing your ability to:

• Identify which penalty exceptions apply to qualified plans only, IRAs only, or both
• Calculate SEPP payments and understand modification consequences
• Apply Roth distribution ordering rules to specific scenarios
• Determine whether NUA strategy is appropriate for a given client
• Understand QDRO taxation and rollover options