Tax planning with substantially equal periodic payments.

Sec. 72(t)(1) generally imposes an additional 10% income tax on amounts received from a qualified retirement plan (as defined in Sec. 4974(c)), to the extent such amount is includible in gross income. For this purpose, the term "qualified retirement plan" generally includes a qualified plan described in Sec. 401 (a), a Sec. 403(b) tax-deferred annuity plan, and individual retirement accounts or annuities (IRAs) described in Sec. 408(a) and (b). There are a number of exceptions to the imposition of this additional 10% tax. Perhaps the most popular exception is for distributions made on or after the date on which the taxpayer attains age 59 1/2 (Sec. 72(t)(2)(A)(i)).

Another exception is allowed under Sec. 72(t)(2)(A)(iv), which provides that the additional 10% income tax does not apply to 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 employee or the joint lives (or joint life expectancies) of the employee and his designated beneficiary. This exception does not apply to distributions from a qualified tax exempt trust (i.e., a Sec. 401(a) plan), unless the series of payments begins after the employee separates from service. This latter requirement is not applicable to IRAs.

Sec. 72(t)(4) provides that, if the series of substantially equal periodic payments is subsequently modified within five years of the date of the first payment (or prior to age 59 1/2), the exception to the 10% tax under Sec. 72(t)(2)(A)(iv) does not apply, and the taxpayer's tax for the year of modification is increased by an amount equal to the tax which, but for the exception under Sec. 72(t)(2)(A)(iv), would have been imposed, plus interest for the deferral period.

Notice 89-25, Q&A-12, provides three methods of distribution by which a series of payments may satisfy the substantially equal periodic payments exception. The distribution methods described in the notice are intended to serve as examples of substantially equal periodic payments and do not represent the only distribution methods that will satisfy the exception.

* Method 1: Payments will be treated as satisfying the substantially equal periodic payment requirement if the annual payment is determined using a method that would be acceptable for purposes of calculating the minimum distribution required under Sec. 401 (a) (9). For this purpose, the payment may be determined based on the employee's life expectancy or the joint life and last survivor life expectancy of the employee and beneficiary. To calculate the distribution, the account balance at the end of the prior year is divided by the participant's life expectancy, or the joint the expectancies (found in tables under Regs. Sec. 1.72-9). This method produces the smallest distribution.

* Method 2, the amortization method: Payments win also be treated as substantially equal periodic payments if the amount to be distributed annually is determined by amortizing the tax-payer's account balance over a number of years equal to the life expectancy of the account owner or the joint the and last survivor expectancy of the account owner and beneficiary at an interest rate that does not exceed a reasonable interest rate on the date payments start. For example, a 50-year-old individual with a the expectancy of 33.1 years, an account balance of 100,000, and (assuming) an interest rate of 8%, could satisfy Sec. 72(t)(2)(A)(iv) by distributing $8,679 annually. This results in a larger distribution than under the first method.

* Method 3, the annuity method: Payments will be treated as substantially equal periodic payments if the amount to be distributed annually is determined by dividing the taxpayer's account balance by an annuity factor (the present value of an annuity of $1 per year beginning at the taxpayer's age attained in the first distribution year and continuing for the taxpayer's life), with such annuity factor derived using a reasonable mortality table and an interest rate that does not exceed a reasonable interest rate on the date payments commence. For example, if the annuity factor for a $1 per year annuity for an individual who is 50 years old is 11.109 (assuming an interest rate of 8% and using the UP-1984 Mortality Table), an individual with a $100,000 account balance would receive an annual distribution of $9,002 ($100,000 [divided by] 11.109). Because this method uses the smallest annuity factor, it results in the largest distribution of the three methods.

As stated in Notice 89-25, the methods described therein serve only as examples. In a number of letter rulings, the IRS has permitted certain variations on the theme, generally including: 1. Using an assumed interest rate equal to 120% of the long-term applicable Federal rate (Letter Ruling 8946045). 2. Calculating distributions after "year one" by applying an adjustment factor related to the changes in the annual defined benefit plan distribution dollar limit to the amount of such "year one" distribution (Letter Ruling 9047043). 3. Allowing a "year one" distribution amount to be calculated using 6% interest, with subsequent distributions remaining constant (Letter Ruling 9604026). 4. Using Pension Benefit Guaranty Corporation assumed interest rates (Letter Ruling 8924093).

Practical Applications

The use of the exception to the additional 10% tax for substantially equal periodic payments can allow taxpayers, particularly IRA owners, to satisfy a variety of financial needs and desires before they attain age 59 1/2, such as to finance the acquisition of a primary or other residence, or to pay for college or graduate school education.

Example 1: Individual T, age 50, is married with two children, ages 16 and 14. College tuition of approximately $15,000 per year is anticipated for the next 10 years. T has an IRA with an account balance of $150,000. The chart below represents the annual distributions assuming a single life expectancy, as well as interest rates and mortality tables used) under each of the methods reflected in Notice 89-25:

Distribution        Annual distribution
method                 amount

Method 1                $ 4,532
Method 2                 13,019
Method 3                 13,503

Although the 10% additional tax will not apply to these distributions, they are included in gross income and subject to ordinary income tax. When a taxpayer can obtain mortgage financing (which produces qualified residence interest), a transaction may be structured to offset the income inclusion with the income tax deduction for qualified residence interest while continuing void this additional 100% tax.

Example 2: X, who has an IRA of $250,000, wishes to purchase a vacation home for $250,000, all of which will be borrowed pursuant to a 30-year mortgage loan at 8% annual interest payable monthly. The mortgage payment is $1,800 per month, or $21,600 per year. X may take distributions from his IRA, as reflected below:

   Distribution       Annual distribution
    method                  amount
    Method 1               $ 7,553
    Method 2                21,698
    Method 3                22,505

The IRA distribution income inclusion may be wholly or partially offset by the interest expense deduction.

A few additional points should be noted. First, the IRS has held that the exception for substantially equal periodic payments does not require that all retirement plans of a taxpayer be aggregated for purposes of the calculation. In Letter Ruling 8946045, the IRS concluded that the owner of multiple IRAs may apply the substantially equal periodic payments exception to one IRA, and not to others. Thus, from a planning standpoint, if the account balance in an IRA is so great that the calculation of substantially equal periodic payment yields an amount in excess of the amount of the annual financial need, such IRA may be bifurcated by rolling over an amount into a separate IRA, leaving the transferor IRA with the amount necessary to satisfy the financial need, when distributed based on the methodology in Notice 89-25. Thus, in Example 2, the IRA had a $400,000 account balance. A new rollover IRA may be established to accept a transfer of $150,000, leaving the transferor IRA to make substantially equal periodic payments.

However, it is equally clear that the entire account balance must be subject to annual distribution. This is illustrated in Letter Ruling 9705033, in which the Service imposed the additional 10% tax when the taxpayer's IRA balance was $462,000, but distributions were calculated using the amount of $406,000.

Qualified Plans Under Sec. 401(a) As previously noted, Sec. 72(t)(3)(B) limits the substantially equal periodic payments exception to distributions from a qualified plan under Sec. 401 (a) until after separation from service.

The constraint applied by Sec. 72(t)(3)(B) may be cumbersome. First, it must be noted that pension plans (i.e., defined benefit plans, money purchase pension plans and plans generally subject to the minimum funding standard of Sec. 412) generally may not permit in-service distributions (Regs. Sec. 1.401-1(a)(2)(i) and (b)(1)(i)). Thus, the requirement that substantially equal periodic payments occur after separation from service to avoid the additional 10% tax is virtually not applicable to pension plans.

Profit-sharing plans may permit in-service distributions. To avoid the constraints of Sec. 72(t)(3)(B), a profit-sharing participant may request an in-service distribution, which is an otherwise "eligible rollover distribution" under Sec. 402(c)(4), and roll it over into an IRA. Such a direct rollover would not be subject to income tax, the additional 100% tax or the 20% withholding tax under Sec. 3405. Once in the IRA, the distribution of substantially equal periodic payments may commence and the exception to the 10% additional tax may be satisfied.

The constraint imposed by Sec. 72(t)(3)(B) may be more difficult to overcome in the case of a Sec. 401 (k) plan. Employee elective pretax deferrals to a Sec. 401 (k) plan are subject to specific statutory withdrawal restrictions, such that distributions may not begin earlier than on separation from service, death, disability, the attainment of age 59 1/2, the hardship of the employee or certain plan terminations or corporate transactions. Although other accounts maintained by an employer in a Sec. 401 (k) plan, such as a profit-sharing account, an employer matching account, a rollover account or other sources of contribution, may be eligible for in-service distribution, elective pretax deferrals are generally only available in-service at age 59 1/2 or on the hardship of the employee.

It appears that a technique to avoid the 10% additional tax on substantially equal periodic payments may be available in the event of a financial hardship, which is a permissible distribution event for employee elective pre-tax deferrals from a Sec. 401 (k) plan. Regs. Sec. 1.401(k)-1(d)(2) deals with the rules applicable to hardship distributions. In general, a distribution is on account of hardship if it is made both on account of an immediate and heavy financial need of the employee and is necessary to satisfy the financial need. Under the so-called "safe harbors," the immediate and heavy financial need requirement is deemed satisfied if the employee represents that the distribution is for: 1. Expenses for medical care of the employee, his spouse, or his dependents; 2. Costs directly related to the purchase of a principal residence for the employee; 3. Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of post-secondary education for the employee, spouse, children or dependents; or 4. Payments necessary to prevent eviction of the employee from his principal residence or foreclosure on the mortgage on that residence.

Thus, when a Sec. 401(k) plan participant can satisfy the plan's criteria for a hardship withdrawal (e.g., post-secondary education costs or purchase of a principal residence), such distribution apparently may be directly rolled over to an IRA, and substantially equal periodic payments may be withdrawn therefrom.

Hardship distributions are eligible rollover distributions and would be subject to 20% income tax withholding unless directly rolled over trustee-to-trustee to an IRA. Thus, for example, in the case of post-secondary tuition expenses, one can borrow the amount of annual tuition from a conventional lending source, and use the hardship distribution that was rolled over into an IRA to repay the loan in a manner that satisfies the exception for substantially equal periodic payments. A similar approach may be used to acquire a principal residence.

From David J. Wasserstrum, CPA, Richard A. Eisner & Company, LLP, New York, N.Y