IRA distributions.

IRC section 72(t) imposes a 10% penalty on early distributions (before age 591/2) from qualified retirement plans. IRA distributions are exempt from this penalty if they are made on account of death or disability or if the payments qualify as "substantially equal." However, if substantially equal payments are modified before the close of the five-year period beginning with the first payment and after the recipient reaches age 59 1/2, then a penalty--known as a recapture tax--is imposed on payments received before age 59 1/2.

Robert Arnold sold his company and retired. He received a distribution from the company's qualified retirement plan, which he rolled into an IRA. In December 1989, at age 55, Arnold received $44,000, the first of a series of equal annual IRA distributions. He received the second distribution in January 1990 and subsequent annual distributions in January of each year. In November 1993, Arnold took an additional $6,700 IRA distribution to offset a reduction in his other income. At the time of this distribution, Arnold was over age 59 1/2 The IRS imposed a 10% recapture tax on all distributions Arnold received before 59 1/2. Arnold appealed to the Tax Court, arguing that the penalty was inappropriate.

Result: For the IRS. The Tax Court rejected Arnold's argument that the five-year modification period ended in January 1993 when he received his fifth annual payment. The court cited the IRC and congressional committee reports, which clearly indicate that the five-year period does not end until five years after the date of the first distribution. In Arnold's case, the five-year period ended in December 1994, as his first distribution had been in December 1989. He had taken the $6,700 distribution that triggered the penalty too soon.

Arnold also claimed that the November 1993 distribution was a cost-of-living adjustment. Although the law permits such adjustments, Arnold did not explain how he calculated the amount or why it was distributed in a lump sum. Therefore, the IRS rejected his argument and imposed the penalty.

A taxpayer who begins receiving IRA distributions before age 59 1/2 must wait five full years before modifying the amount of the periodic distribution. Being over age 59 1/2 at the time of the modification does not change this requirement. Although distributions can be adjusted for changes in the cost of living, such adjustments must be based on a recognized measure, such as the Consumer Price Index, and paid as part of the annual distribution. Premature changes will result in the imposition of the 10% recapture tax, plus interest.

Robert C. Arnold v. Commissioner, 111 TC no. 12.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.