Combating the market: no penalty for reduced retirement distributions. (Federal Tax).

Rev. Rul. 2002-62 (IRB 2002-42, 10/21/02) will enable some taxpayers to maintain their retirement savings when there is an unanticipated decline in the value of those savings.

These taxpayers began receiving fixed payments from their IRAs or other retirement plans based on the value of those accounts at the time they started receiving payments. Those taxpayers may now switch, without penalty, to a method of determining the amount of their payments based on the value of their accounts as they change from year to year.

Background

Generally, under IRC Sec. 72(t)(1), taxpayers are subject to a 10-percent tax, in addition to the regular income tax, on amounts withdrawn from their IRAs or employer-sponsored qualified retirement plans before attaining age 59 1/2. However, there are several exceptions to this additional tax.

One of these exceptions applies if a taxpayer takes distributions that are part of a series of substantially equal periodic payments (made at least once a year) over the taxpayer's life expectancy or the joint life expectancies of the taxpayer and his or her beneficiary [Sec. 72(t)(2)(A)(iv)].

The IRS issued guidance (Q&A 12 in Notice 89-25) that provided three safe-harbor methods for satisfying this exception.

Two of these methods require a fixed amount that must be distributed and could result in the premature depletion of the taxpayer's account in the event that the value of the assets in that account declines.

However, under Sec. 72(t)(4), the exception to the 10-percent tax for substantially equal periodic payments will not apply if these payments are subsequently modified, other than by reason of death or disability, before:

* The close of the five-year period beginning with the date of the first payment and after the taxpayer attains age 59 1/2;or

* The taxpayer attains age 59 1/2.

In this event, the tax for the year in which the modification occurs is increased by an amount which, but for this exception, would have been imposed, plus interest for the deferral period.

This period begins with the tax year in which the distribution would have been includible in gross income, absent the exception, and ending with the tax year in which the modification occurs.

New Treatment

Rev. Rul. 2002-62 provides relief to tax payers who selected one of these two fixed-payment safe-harbor methods by permitting them to make a one-time change from such a method to the third safe-harbor method, where the amount changes from year to year based on the value of the account from which the distributions are made.

Rev. Rul. 2002-62 also clarifies how an individual can satisfy this third safe harbor that tracks the Sec. 401(a)(9) required minimum distribution rules light of the recent final regulations implementing those rules.

In addition, this ruling provides guidance on what constitutes a reasonable interest rate to determine payments which satisfy the substantially equal periodic payment requirement. And it provides a choice of mortality tables that can be used to satisfy the permitted methods.

Bad News, Good News

The bad news: Using an acceptable method of determining substantially equal periodic payments, which are fixed in amount, may cause an individual's assets in an individual account plan or an IRA to be exhausted.

The good news: This individual will not be subject to the additional 10 per cent tax if they do not receive substantially equal periodic payments. Also, the resulting cessation of payments will not be treated as a modification of the series of payments. [Rev. Rul. 2002-62, Section 2.03(a)].

Analysis

This one-time opportunity to change the safe-harbor method can avoid the premature depletion of an account that has dropped in value because of market conditions from the time that the individual (pre-age 59 1/2) began receiving distributions under a safe-harbor method requiring fixed payments regardless of changes in the account's value.

Conversely, if this change is made and the account then experiences substantial appreciation in value, subsequent payments could be higher than they would have been under the original safe-harbor method.

Rev. Rul. 2002-62 allows taxpayers great leeway in fashioning distributions to avoid the 10-percent additional tax and still withdraw funds from their IRAs to meet their financial needs.

This ruling permits taxpayers who selected a fixed payment safe-harbor method to change to a safe-harbor method that will decrease or increase their payments if investment results cause their account values to subsequently decrease or increase.

It is possible to subdivide an IRA into two (or more) IRAs and change the safe-harbor method for only one (or more) of the resulting new IRAs to obtain more flexibility in arranging IRA distributions.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA 's Committee on Taxation, can be reached at (619) 4696999 or [e-mail].