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Individual retirement accounts: early withdrawals and changes for 1997.

After the Tax Reform Act of 1986, few people contributed to their Individual Retirement Accounts (IRAs). The contribution seemed to be less valuable since its tax deductibility for participants in a company pension plan is completely phased out for individuals who earn more than $35,000 if single and $50,000 if married. But wealth can be built up much faster in an IRA than in most other investment programs. For many taxpayers, combined federal and state income taxes consume at least 33% of every investment dollar earned. Therefore, investments within an IRA can provide superior returns because they grow on a tax-deferred basis.

Increased Spousal IRAs

If taxpayers have contributed the maximum allowed to various tax-deferred programs, they should consider contributions to IRAs, particularly for nonworking spouses, who will be permitted a $2,000 spousal IRA contribution beginning in 1997 instead of the $250 currently permitted if the combined compensation of both spouses is at least equal to the amount contributed to the IRA. This provision was enacted in the Small Business Job Protection Act of 1996 and is effective for tax years beginning after December 31, 1996. Deductibility is determined as before but, as mentioned above, the important feature is tax-deferred growth.

Early Withdrawal Penalties

With rollovers from company plans, billions of dollars have been deposited in IRAs. For many people the question then becomes how to withdraw funds with the least tax consequences. Section 72 of the Internal Revenue Code provides rules for determining how amounts received as annuities and distributions from qualified plans are to be taxed. The Tax Reform Act of 1986 added Section 72(t)(1), which provides for the imposition of an additional 10% tax on early distributions from such plans, including IRAs. The additional tax is imposed on the portion of the distribution which is includible in gross income. An early distribution is a withdrawal before age 59 1/2. Therefore, there is no penalty if withdrawals take place after age 59 1/2.


Death and Disability

The penalty does not apply if the distribution is to a beneficiary or to the estate of the employee after the death of the employee or in the case of a distribution to a disabled employee.

Medical Expenses

The Small Business Job Protection Act of 1996 amended Section 72(t)(2)(B) which provides for early withdrawals without penalties to pay for medical expenses for a taxpayer, spouse or dependents to the extent that the expenses exceed 7 1/2% of AGI. This amount may be withdrawn penalty-free regardless of whether the taxpayer itemizes deductions for that year. Of course, such withdrawals are still subject to regular income tax, offset by a medical expense deduction if the taxpayer itemizes.

Medical Insurance Expense

Early distributions are also penalty-free under 72(t)(2)(D) if they are used to pay for medical insurance if the taxpayer has received unemployment compensation for at least 12 weeks and the distribution is made in the year that the unemployment compensation was received or in the following year. This exception is no longer in effect after a taxpayer has been reemployed for at least 60 days. These provisions become effective for tax year 1997.

Withdrawals in Substantially Equal Payments

Section 72(t)(2)(A)(iv) provides that withdrawals of a series of substantially equal periodic payments made for the life or life expectancy of the employee, or for the joint lives of the employee and a beneficiary, are not subject to the early withdrawal penalty.

Notice 89-25 (1989-1 C.B. 662) explains what constitutes a series of substantially equal periodic payments for purposes of the above Internal Revenue Code section. The following three methods meet these requirements.

* Section 401 (a)(9) determines the minimum distribution requirement for taxpayers required to begin withdrawals after age 70 1/2. The same computation can be used to determine the required distribution for early withdrawals. The taxpayer's life expectancy and that of the oldest beneficiary, if applicable, is determined from Tables V or VI of Regulation Section 1.72-9. The account balance as of December 31 of the preceding year is divided by this life expectancy. This is the payment for the first year. Life expectancies will be recalculated each year, and payments will also reflect the changing account balance from year to year.

* Under the second method, the annual distribution is determined, on the date payments begin, by amortizing the taxpayer's account balance over the life expectancy of the taxpayer, or the joint life expectancies of the taxpayer and a beneficiary, at an interest rate which does not exceed a reasonable rate. In several Letter Rulings, life expectancies were not recalculated each year. Therefore, the amount to be distributed did not change. As to what constitutes a reasonable rate, Letter Ruling 9531039 approved an interest rate equal to the annually compounded midterm federal rate in effect on January 1 of the distribution year.

* The third method is similar to the second but uses a reasonable mortality table instead of the IRS tables. The account balance is divided by an annuity factor taken from the mortality table and based on a reasonable interest rate. Subsequent distributions will be calculated in a similar manner using the account balance as of December 31 of the prior year divided by the annuity factor derived from the mortality tables, the age in the distribution year and the interest rate in effect on January 1 of the distribution year.

Though it is not spelled out in Notice 89-25 or any of the rulings, withdrawing money from just one IRA and basing the withdrawal on the balance in that account may be acceptable. Proposed regulation 1.401(a)(9)-1 treats separate plans and accounts separately in applying minimum distribution rules. IRAs may be aggregated in order to make it easier to achieve the required withdrawals after age 70 1/2. Since early withdrawals are at the taxpayer's discretion, an employee may wish to draw from only one account if he or she has several IRAs.

Modification Penalty

Section 72(t)(4) imposes an additional limitation on distributions excepted from the 10% tax by Section 72(t)(2)(A)(iv). If the series of payments is subsequently modified before the later of (1) the close of the five-year period beginning with the date of the first payment or (2) the date on which the individual reaches age 59 1/2, then the taxpayer will incur the additional penalty tax plus interest for the deferral period in the year such modification takes place. The employee's death or disability are the only reasons which permit a modification of the pay-out without incurring additional taxes and interest.

Excess Distributions

The above provisions are helpful for individuals wishing to retire early, but may be even more helpful for taxpayers with large accumulations in qualified retirement plans, tax-sheltered annuities or IRAs. Aggregate distributions from these plans in excess of indexed amounts - $155,000 for 1996 - are subject to a 15% excise tax. Therefore, an early withdrawal plan from an IRA could prevent an excess distribution later on.

The Small Business Act will temporarily suspend the 15% excise tax for excess withdrawals in any amount from any tax-deferred plan for calendar years 1997, 1998 and 1999. Taxpayers over age 59 1/2 thus have a window of opportunity to reduce future tax liabilities. Those less than 59 1/2 years old would, of course, be subject to the early withdrawal penalty for distributions which do not conform to any of the permitted payout plans or meet other expectations.

Despite the sometimes complicated rules, employee and nonworking spouse contributions to IRAs are still valuable, whether or not the contribution is currently deductible. Tax-free compounding of earnings over the worker's lifetime can provide a tidy nest egg for the future.

Helga B. Foss, PhD, CPA, is an associate professor of accounting at Ball State University in Muncie, Indiana.
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Author:Foss, Helga B.
Publication:The National Public Accountant
Date:Jan 1, 1997
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