Chapter 15: early distribution planning techniques.
A 10% penalty tax applies to early distributions from qualified plans and IRAs. The tax applies only to the amount of the distribution that is includable in income. In general, an early distribution is a distribution made before age 59 1/2, death, or disability unless another exception applies. An important exception (discussed in detail below) is for payments that are part of a series of substantially equal periodic payments (SEPPs).
The early distribution penalty tax is designed to discourage people from taking distributions from their tax-favored retirement accounts prior to retirement. It is unlikely to affect many people who are seeking retirement income because of the relatively low age of 59 1/2 and the disability exception. However, if, because of an emergency or opportunity, a person wants to or needs to withdraw amounts prior to age 59 1/2, planning using an exception can help avoid the penalty tax (although it will not, of course, avoid the regular income tax on the distribution).
WHEN IS THE USE OF THIS DEVICE INDICATED?
Planning for early distributions may be indicated whenever a plan participant or IRA owner is under age 59 1/2, has qualified plan or IRA assets, and needs additional funds for expenditures.
1. Planning using an exception to the 10% early distribution penalty tax avoids the penalty tax.
2. Even if an exception is not available, the penalty tax applies only to the portion of the distribution includable in income.
3. Even if an exception is not available, the penalty tax can be partially or wholly offset over time by the tax benefits, such as tax deductions or exclusions and tax deferral, of the tax favored retirement plan.
4. The early distribution tax may encourage greater retirement accumulations by discouraging distributions.
1. Without proper planning, the early penalty tax will generally apply to distributions made before age 59 1/2, death, or disability and significantly reduce the net amount obtained from the distribution.
2. The exceptions, or potentially low penalty tax, make it easy to withdraw amounts, and thus reduce accumulations for retirement.
WHAT ARE THE TAX IMPLICATIONS?
1. Failure to qualify for an exception to the early distribution penalty tax results in a 10% penalty tax to the extent the distribution is includable in income. The early distribution rules are discussed in detail below.
2. Making an early distribution generally ends the tax deferral in the tax advantaged retirement account for the amount distributed.
EARLY DISTRIBUTION PLANNING
IRC Section 72(t) imposes a 10% additional tax on early distributions from an IRA or a qualified retirement plan. For purposes of this chapter, the 10% additional tax will be referred to as the 72(t) or the 10% penalty.
Promulgated with the legislative intent of encouraging saving for retirement by effectively discouraging taxpayers from taking early distributions from their qualified plans and individual retirement accounts and thus depleting their retirement savings, Congress established the 10% penalty under Section 72(t). Often referred to as the "premature distribution penalty," this penalty generally applies, absent a specific exemption, when an individual receives a distribution from an IRA prior to attaining age 59 1/2, or from a pension plan if the individual separates from service before the year in which the individual turns age 55 (50 for public safety employees).
The 10% penalty is assessed to the extent the distribution is included in gross income. Therefore, distributions which are not included in the computation of gross income (i.e., distributions that represent a tax-free return of basis, tax-free trustee-to-trustee transfers, or otherwise taxable distributions that are rolled over into an eligible retirement plan within the prescribed 60-day period) will not be assessed the additional 10% tax.
Example: John Smith, age 53, takes a $20,000 distribution from his individual retirement account. In this case, since John has not attained the age of 59 1/2, and assuming the entire distribution is included in John's gross income, a $2,000 penalty ($20,000 x 10%) is imposed on the early distribution. Example: Jane Doe, age 53, takes a $40,000 distribution from her pension plan while she is still employed. In this case, because Jane has not separated from service from this employer and has not attained the age of 55, and assuming she will include the entire distribution in her gross income, a $4,000 penalty ($40,000 x 10%) will be imposed on the distribution.
The 10% penalty becomes a 25% penalty on nonqualified distributions from SIMPLE IRA plans made prior to age 59 1/2 if the distribution takes place within a two year period commencing on the date the employee first participates in any SIMPLE IRA maintained by the employer. (1) If the early distributions are made after this two-year period, they are then subject to the regular 10% penalty.
Example: Betty, age 56, takes a $20,000 distribution from her SIMPLE individual retirement account on June 30, 2007. She first began participating in the SIMPLE IRA maintained by her employer on January 1, 2006. In this case, since Betty has not attained the age of 59 1/2, and is within the two-year time frame defined, and assuming the entire distribution will be included in Betty's gross income, a $5,000 additional tax or penalty ($20,000 x 25%) will be imposed on the early distribution.
EXCEPTIONS TO THE 72(t) PENALTY
Like many provisions of the Internal Revenue Code, there are a number of exceptions to the 10% penalty. The financial advisor must be knowledgeable about these exceptions because a taxpayer who takes an early distribution from a qualified retirement plan will be subject to the 10% penalty unless one of the specific exceptions applies. This is a bright line rule and the IRS does not make exceptions.
Specifically, IRC Section 72(t)(2) provides the following exceptions:
* Attainment of age 59 1/2
* Series of substantially equal periodic payments (SEPP)
* Early retirement--attainment of age 55 or older in the year of separation from service (not applicable to IRAs)
* Medical expenses--to the extent they exceed 7.5% of adjusted gross income
* Made pursuant to a qualified domestic relations order (QDRO)
* Payment of health insurance premiums by unemployed individuals
* Payment of qualified higher education expenses (applicable to IRAs only)
* First time home purchase, limited to $10,000 for a lifetime (applicable to IRAs only)
* Section 404(k) stock dividends
* Tax levies
* Individuals called to active duty--qualified reservist distribution
While some of these exceptions are rarely utilized, many of them are frequently used and should be thoroughly understood by the financial advisor. Of the exceptions listed above, the first five are the most important and the most utilized. They will therefore be discussed in detail.
Attainment of Age 59 1/2
Perhaps the most recognized and understood exception to the [section]72(t) penalty is the exception for taxpayers who have attained the age of 59 1/2. The 10% penalty does not apply to any distributions which are made on or after the date that the account owner attains the age of 59 1/2. (2) Therefore, any early distributions, from any type of plan, made after the date in which the account owner turns 59 1/2 will be exempt from the 10% penalty. However, the financial advisor should be cognizant to not forget that this amount is still subject to income tax, to the extent included in gross income.
Example: Sam, age 59 and born on January 15, 1948, takes a $10,000 distribution from his IRA on June 1, 2007. In this case, since Sam has not attained the age of 59 1/2, and assuming the entire distribution will be included in Sam's gross income, a $1,000 penalty ($10,000 x 10%) will be imposed on the early distribution. Although Sam was 59 when he took the early distribution, and would turn 59 1/2 later that year, he was not 59 1/2 on or after the date of the distribution. The IRS interprets this section of the Internal Revenue Code very literally. The taxpayer must be at least 59 1/2, to the day, on the date of the distribution in order for the exception to apply. In Sam's case, he will turn 59 1/2 on July 15, 2007 (exactly 6 months after his 59th birthday). Assume the same facts as above, except that Sam took the early distribution on July 16, 2007. In this case, because Sam turned 59 1/2 on July 15, 2007, the exception will apply and Sam will not be subject to the 10% penalty. Moreover, he could have taken the distribution one day earlier, on July 15, 2007, and the exception still would have applied. However, if he chose to take the distribution on July 14, 2007, he would be subject to the 10% penalty. As a word of caution, when relying on this exception to the 10% penalty, the financial advisor must be very careful to correctly compute the date on which the taxpayer turns age 59 1/2.
The 10% penalty does not apply to early distributions which are made to a beneficiary (or to the estate of the employee) on or after the death of the employee. (3) The exemption is applicable regardless of the beneficiary's age and the type of plan involved, whether it is an employer sponsored plan or an IRA.
Although this exemption is relatively straightforward, the financial advisor should be cautioned regarding the spousal rollover trap. If a surviving spouse takes the death benefits inherited from the deceased spouse and rolls the funds over into her own IRA, then these rolled over funds cease to qualify for the 10% early withdrawal penalty exclusion based on the first spouse's death. Once rolled into the surviving spouse's name, the funds are no longer considered death benefits, they instead are treated as part of the surviving spouse's own IRA and any early distributions from the surviving spouse's IRA will be subject to the 10% penalty unless an exception applies.
As a planning point, and taking into consideration the surviving spouse's financial needs, the surviving spouse may want to consider leaving some or all of the death benefits in the deceased spouse's plan until the surviving spouse reaches age 59 1/2. In the alternative, the surviving spouse may wish to roll all or a portion of the death benefits over immediately into her own IRA and then utilize the series of substantially equal periodic payments exception (see below) to withdraw funds.
Furthermore, the surviving spouse could also roll the death benefits from the plan into an IRA in the deceased spouse's name. This allows the death benefits to maintain their favorable 72(t) status. In deciding which alternative or mix of alternatives to employ, the prudent financial advisor should determine the best course of action for the client, based on the client's needs and income tax situation.
Example: Jane, age 47, is the surviving spouse of Bill, who recently passed away at the age of 52, leaving behind an IRA in the amount of $480,000. Although Jane is only 47, and Bill had not attained the age of 59 1/2 when he died, if Jane takes distributions from Bill's IRA after his death the entire amount of the distributions will be exempt from the 10% penalty. However, if, after his death, Jane decides to roll all or part of Bill's IRA into her own IRA, any distributions Jane would subsequently make from her own IRA prior to attaining the age of 59 1/2 would be subject to the 10% penalty unless an exception applies.
Relief is also provided from the 10% penalty when a taxpayer makes pre-59 1/2 withdrawals after they have become disabled. The 10% penalty does not apply to early distributions which are attributable to the employee's being disabled. (4)
Disabled is defined as "unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the [IRS] may require."5 The financial advisor should be cautious to use this exception except in situations of unquestionable disability.
Another of the well known exceptions to the 72(t) penalty is the early retirement exception. The 10% penalty does not apply to distributions made to an employee after separation from service after attainment of age 55.6 This basically means that the 10% early withdrawal penalty does not apply to distributions which are made to an employee who has retired after turning 55.
In utilizing this exception, the financial advisor needs to be aware that this exception does not apply to IRAs; it applies only to an employer's qualified retirement plan. Furthermore, the employer from which the employee has separated must be the plan sponsor of the plan from which the separated employee is now making withdrawals. Additionally, the employee does not have to be 55 when the separation from service takes place; rather he must turn 55 in the year he separates from service. Therefore, as a planning point, the employee could separate from service on January 1st and turn 55 on December 31st and still qualify for the exemption for that entire year and subsequent years. Notably, if the employee separates from service prior to the year in which he turns 55, he is not eligible for penalty-free withdrawals merely upon reaching age 55; he must have actually separated from service in the year he turns 55 (or a subsequent year).
As an additional planning point, due to the fact that this exception does not apply to IRAs, the financial advisor may want to caution clients who have reached the age of 55 (50 for public safety employees) but have not yet attained the age of 59 1/2, about rolling qualified retirement plan assets into an IRA. If the client is planning on making pre-59 1/2 withdrawals from his retirement account, he will want to maintain his assets in the qualified retirement plan and abstain from rolling the assets over into an IRA. As the early retirement exception applies only to qualified retirement plans, if the client leaves his funds in the qualified plan, he will be free to utilize this exception and withdraw funds prior to attaining age 59 1/2. However, if he rolls the assets into an IRA, he will not be able to utilize this exception and will have to wait until reaching age 59 1/2 to make penalty-free withdrawals unless another exception applies. This is an important planning strategy which can have a significant impact on clients who are planning to retire early and want to make pre-59 1/2 withdrawals from their retirement assets.
The Pension Protection Act of 2006 added a special rule for public safety employees who have reached the age of 50. A public safety employee may retire early, at the age of 50 instead of 55, and use this exception to take distributions from their qualified plans penalty-free. A public safety employee includes "any employee of a State or political subdivision of a State who provides police protection, firefighting services, or emergency medical services for any area within the jurisdiction of such State or political subdivision." (7)
Example: Frank, age 49, decided to retire early from his job as a fireman and separated from service on July 31. His 50th birthday was on October 2 of that year and on November 1 Frank took a $20,000 distribution from his fire department pension plan. Due to the special rule for public safety offices, which effectively reduces the early retirement age from 55 to 50 for this class of employees, the $20,000 early distribution will not be subject to the 10% penalty. Notably, even if Frank took his distribution on August 1 (after separating from service, but before his 50th birthday), he would have still been eligible for the exception because he separated from service in the year in which he was turning 50.
Series of Substantially Equal Periodic Payments
Of all of the previously listed exceptions to the 72(t) penalty, the series of substantially equal periodic payment (SEPP) exception provides taxpayers and financial advisors with the most beneficial planning opportunities (and also some of the most significant traps and pitfalls). Generally, when individuals retire prior to age 59 1/2 and roll their funds into an IRA, they avail themselves of the SEPP exception to the 72(t) penalty. Although the SEPP exception applies to qualified retirement plan assets, it applies only if the participant has separated from service. Conversely, the exception is allowed for IRAs even if the IRA owner is still working. Therefore, an employee can strategically convert their qualified retirement assets into an IRA and then avail themselves of the SEPP exception. In applying this strategy, the employee is able to make pre-59 1/2 withdrawals from their retirement assets without incurring the 10% penalty.
Although the SEPP exception provides many taxpayers with the opportunity to withdraw funds from their retirement accounts penalty-free prior to reaching the age of 59 1/2, the benefits attained through the use of this exception do not come without a price. For example, the SEPP exception cannot be combined and used with any of the other exceptions, and the payments must continue until the later of attainment of age 59 1/2 or five years. Furthermore, once SEPP payments have begun, they cannot be modified without incurring a retroactive application of the 10% penalty. (8)
The SEPP exception basically states that a taxpayer is allowed to withdraw equal or substantially equal amounts from a deferred account (i.e., an IRA), on at least an annual basis, for a period based on the IRA owner's life expectancy or the joint life expectancy of the owner and his designated beneficiary, without being subject to the 10% penalty. Furthermore, the amount of the withdrawal cannot be modified until the later of the following to occur: the taxpayer attains age 59 1/2 or five years elapses.
Once a taxpayer has taken the first SEPP withdrawal, the taxpayer cannot thereafter materially modify any further SEPP withdrawals until the
later of five years or the date the taxpayer attains age 59 1/2. If the taxpayer makes a material modification, the taxpayer will then be subject to a 10% penalty for all of the years in which the taxpayer made pre-age 59 1/2 withdrawals.
Additionally, the taxpayer will also be subject to interest on the penalty amount, computed from the first year of the SEPP withdrawal. Essentially, if a material modification is made, the 10% penalty will be applied retroactively to all SEPP withdrawals along with late payment interest. This can be very costly for a taxpayer and care should be taken to avoid this situation if at all possible.
Example: Madelyn, age 50, began making pre-59 1/2 withdrawals in 2001 under the SEPP exception using the amortization method. Her yearly withdrawals for the years 2001 through 2006 were $25,000. In 2007, Madelyn suffered some financial difficulties and withdrew an additional $15,000 from her IRA for a total withdrawal in 2007 of $40,000. As a result of this material modification to the SEPP withdrawals, Madelyn will be subject to the 10% penalty for her 2007 SEPP withdrawal as well as all of her previous SEPP withdrawals, plus late payment interest. Therefore, the 10% penalty will be assessed retroactively and all of Madelyn's SEPP withdrawals from 2001-2007 will be subject to the 10% penalty. In addition, Madelyn will be assessed late payment interest on the delinquent payment of the penalty, beginning with the date of her first SEPP withdrawal. Assuming an 8% annual interest rate (and daily compounding) on the underpayment, the total penalties and interest that Madelyn will pay are as follows: Accrued 10% Interest Total Penalty @ 8% 2001 Tax Year $2,500 $1,540 $4,040 2002 Tax Year 2,500 1,229 3,729 2003 Tax Year 2,500 943 3,443 2004 Tax Year 2,500 678 3,178 2005 Tax Year 2,500 434 2,934 2006 Tax Year 2,500 208 2,708 2007 Tax Year 4,000 0 4,000 TOTALS $19,000 $5,032 $24,032
As a planning point, the financial advisor should caution clients who are nearing the age of 59 1/2 from using the SEPP exception. This is because they run the risk of having to make SEPP withdrawals and being subject to the modification rules after attaining the age of 59 1/2. This is because the modification rule states that once SEPP payments commence, the taxpayer may not materially modify any further SEPP withdrawals until the later of five years or when the taxpayer attains the age of 59 1/2. If, for example, a taxpayer begins making SEPP payments at age 56, they must continue payments after they have turned 59 1/2 and until they reach age 61 (i.e., the later of 59 1/2 or five years). Thus, if the taxpayer could have found other means to handle cash flow needs from age 56 to 59 1/2, the taxpayer would have far more flexibility after age 59 1/2 by not having started SEPP withdrawals at age 56.
In addition to the above, care must be given to ensure that no rollovers are made either to or from the IRA during the SEPP withdrawal period. This situation is of particular concern for clients who have done rollovers from qualified retirement plans (e.g., 401(k)s) to IRAs whereby the client signs a blanket document requesting that all trailing distributions from the qualified retirement plan be directly rolled over to the IRA. Should this happen, the IRS will take the position that a material modification has occurred, thus subjecting the taxpayer to the 10% penalty retroactively. Accordingly, in order to prevent this event from occurring, the client should create a separate IRA from which the SEPPs will be withdrawn.
As an additional planning point, the financial advisor should be aware that in a recent private letter ruling request, the IRS ruled that modification of an annual SEPP payment resulting from a Judgment of Divorce may not constitute a material modification, and thus would not subject the owner to the retroactive application of the 10% penalty.
Revenue Ruling 2002-62 provides three methods for determining the amount which will constitute a SEPP. These three methods are the:
* Required Minimum Distribution (RMD) Method
* Fixed Amortization Method
* Fixed Annuitization Method
As a planning point, the prudent taxpayer will calculate his SEPP payment under each of these three methods and then chose the method which produces the payment that best fits the taxpayer's current and expected future needs. The taxpayer can switch to the RMD method in a later year.
The calculation of the SEPP amount is comprised of three primary factors. These factors are the balance of the retirement account, the reasonable interest rate, and the life expectancy of the owner (or the joint and survivor life expectancies of the owner and his beneficiary).
1. The balance of the retirement account
* The taxpayer must use a reasonable valuation date in arriving at the retirement account balance. A reasonable valuation date is December 31 of the year preceding the payment, or any reasonable date between December 31 of the preceding year and the date of that year's distribution.
2. The mid-term applicable federal interest rate (AFR). (9)
* A reasonable interest rate is an interest rate which does not exceed 120% of the federal mid-term interest rate for either of the two months which proceed the month of the first SEPP payment. This represents the highest interest rate that may be used. A taxpayer is allowed to use a lower rate, although this may not be advisable.
3. The life expectancy of the participant (or joint and survivor lives)
* The taxpayer can choose one of the three life expectancy tables (see Appendix E) to determine the distribution period. These three tables are the:
* Uniform life table
* Single life expectancy table
* Joint and last survivor table
Required Minimum Distribution Method
Under the required minimum distribution method, the annual payment for each year is calculated by dividing the account balance for that year by the number from the chosen life expectancy table for that year. Thus, in using this method, the annual payment is redetermined each year based on that year's account balance and number from the life expectancy table. Although the required distribution method may result in the amount of the payment varying from year to year, for purposes of the application of the modification provisions of 72(t), utilization of this method will not constitute a modification provided the taxpayer does not change computation methods.
Example: Mike, age 54 and single, would like to withdraw funds from his IRA using the substantially equal periodic payments exception to IRC Section 72(t). He has decided to utilize the required minimum distribution method to calculate his withdrawals and plans to make the first withdrawal on January 1, 2007. Assume that Mike has a balance of $1,200,000 in his IRA on December 31, 2006, and that he will use the Uniform Lifetime Table to determine the life expectancy factor. On January 1, 2007, Mike would make a $28,169 distribution from his IRA, penalty-free, calculated as follows: A. Balance in IRA account (12/31/2006) $1,200,000 B. Mike's Life Expectancy Factor 42.6 C. Mike's 2007 IRA Distribution [A / B] $28,169
Fixed Amortization Method
Under the fixed amortization method, the annual payment for each year is calculated by amortizing the account balance in level amounts over a specified number of years, determined using the chosen life expectancy table and the chosen interest rate. (10) Thus, unlike the required distribution method, in utilizing this method, the annual payment is computed once and thereafter does not vary (a one-time switch to RMD method is available).
Example: Assuming the same facts as above, except that Mike has chosen to utilize the fixed amortization method to calculate his substantially equal periodic payments with annual payments to be made at the beginning of each period. Assuming an interest rate of 5.70% (120% of the federal mid-term rate of 4.75%) and the single life expectancy table, Mike would make a $79,340 distribution from his IRA on January 1, 2007, penalty-free, calculated as follows: A. Balance in IRA account (12/31/2006) $1,200,000 B. Annuity factor (30.5 years) 14.3091 C. Annuity adjustment factor 1.0570 D. Mike's 2007 IRA Distribution [A / (B x C)] $79,340
Fixed Annuitization Method
Under the fixed annuitization method, the annual payment for each year is calculated by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer's age and continuing for the life of the taxpayer (or the joint lives of the individual and beneficiary). (11) Therefore, as with the amortization method, in utilizing this method the annual payment is computed once and thereafter does not vary (a one-time switch to RMD method is available).
Example: Assuming the same facts as above, except that Mike has chosen to utilize the fixed annuitization method to calculate his substantially equal periodic payments with annual payments to be made at the beginning of each period. Assuming an interest rate of 5.70% (120% of the federal mid-term rate of 4.75%) and a single life expectancy table, Mike would make a $82,005 distribution from his IRA on January 1, 2007, penalty-free, calculated as follows: A. Balance in IRA account (12/31/2006) $1,200,000 B. Annuity factor (age 54) 13.6333 C. Annuity adjustment factor 1.000 D. Mike's 2007 IRA Distribution [A / ((B x C) + 1)] $82,005
Multiple IRA SEPP Strategy
In order to overcome the negative implications of the retroactive application of the 10% penalty due to an inadvertent or a deliberate material modification in SEPP withdrawals, the prudent taxpayer may benefit by employing a multiple or segregated IRA SEPP strategy.
In utilizing this strategy, the taxpayer creates two or three IRAs and only uses the annuitization or amortization method to take withdrawals from one or two of the IRAs, allowing the remaining IRA to sit idle until it will be needed for emergencies.
Accordingly, a taxpayer carves out a portion of his total IRA (IRA #1) and establishes a separate IRA (IRA #2) from which to make SEPP withdrawals. The original IRA (IRA #1), remains pristine and is allowed to grow. The second IRA, (IRA #2) which will be amortized over the owner's lifetime (or the joint lives of the owner and their beneficiary), is established for the sole purpose of the SEPP withdrawals.
Should the taxpayer encounter contingences where additional cash flow is needed or need to increase the total of the SEPP withdrawals, the taxpayer will be able to create an additional separate IRA (IRA #3), or make emergency distributions from the original IRA (IRA #1), without materially modifying the SEPP payments in the second IRA (IRA #2). As such, the taxpayer is allowed flexibility without incurring the retroactive application of the 10% penalty.
Although Section 72(t) poses a problem for many taxpayers, with proper planning and the strategic utilization of the SEPP exception, many taxpayers are able to accomplish early, penalty-free withdrawals from their retirement accounts. Especially in this day and age when layoffs and financial crisis are impacting taxpayers in their 40's and early 50's, the ability of the financial advisor to help their clients access their retirement funds without subjecting themselves to costly penalties is imperative. It is beneficial for the financial advisor to have a good working knowledge of the application of the 72(t) penalty and its related exceptions.
(1.) IRC Sec. 72(t)(6).
(2.) IRC Sec. 72(t)(2)(A)(i).
(3.) IRC Sec. 72(t)(2)(A)(ii).
(4.) IRC Sec. 72(t)(2)(A)(iii).
(5.) IRC Sec. 72(m)(7).
(6.) IRC Sec. 72(t)(2)(A)(v).
(7.) IRC Sec. 72(t)(10).
(8.) IRC Sec. 72(t)(4)
(9.) This rate is published by the IRS and can be found each month at leimberg.com and taxfactsonline.com.
(10.) Rev. Rul. 2002-62, section 2.01(b).
(11.) Rev. Rul. 2002-62, section 2.01(c).
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|Title Annotation:||Part 4: TAX CONSIDERATIONS|
|Publication:||Tools & Techniques of Retirement Income Planning|
|Date:||Jan 1, 2007|
|Previous Article:||Chapter 14: rollover planning strategies.|
|Next Article:||Chapter 16: required minimum distributions.|