Planning 10 avoid the premature distribution penalty: the benefits and Disadvantages of IRC section 72(t).
Income tax provisions related to retirement plans have become extremely complex--and, at times, nearly incomprehensible. Individuals and their tax advisors should acquaint themselves with the options available in order to plan for IRA distributions that avoid a common pitfall in retirement planning: the penalty for premature distributions.
Most retirement plans allow for either a current income tax deduction or W-2 income reduction in the amount of the contribution to the plan. In addition, the investments in these plans build up tax free until the time of distribution. This immediate income tax deduction, coupled with the tax-five buildup, makes such retirement plans one of the most useful investment vehicles available to taxpayers. All is well as long as the taxpayer does not need these funds until retirement, because Congress imposes a 10% penalty on early distribution from these plans in order to ensure that the money is used for its intended purpose of providing retirement income to the account owner (IRC section 72[t]).
Another penalty of 50% applies to taxpayers who fail to make required distributions upon turning age 701/4 (IRC section 409[a]). The government imposed the 10% penalty to help ensure that taxpayers would not tap into their retirement accounts until after retirement (i.e., after age 591/4), but also would not structure their retirement accounts to permanently escape taxation; thus, the 50% penalty motivates taxpayers to make the required minimum distributions (RMD).
Yet, life does not always work out as planned. What if a taxpayer needs to tap into these funds prior to retirement for valid reasons? Should this penalty apply? Taxpayers might need funds because they lost their job, lost a loved one, encountered unexpected medical or educational expenses, or went through a divorce. In addition, taxpayers might need funds due to a severe economic disruption, such as the current ongoing crisis.
There are several ways for taxpayers to receive limited amounts of distribution from their retirement plans penalty free. Even though amounts might qualify for penalty-free distribution, they are usually subject to income taxation. This discussion will introduce several available methods of receiving penalty-free distributions from an IRA, as well as exceptions to the penalty; it will also focus on the substantially equal periodic payment (SEPP) method for avoiding the penalty on premature distributions, the general requirements to qualify for the SEPP method, the calculations made under this method, the SEPP method's advantages and disadvantages, IRS filing requirements, and planning opportunities for taxpayers and their financial advisors.
As mentioned above, IRC section 72(t)(1) provides for a 10% penalty on the amount of premature retirement plan distribution included in a =payer's gross income. A distribution is considered to be premature if it does not meet one of the exceptions under [RC section 72(t). Congress has provided fairly liberal exceptions to this penalty, including distributions that are--
* made on or after the taxpayer attains the age of 591/2 (IRC section 72[t][A][i]);
* made to a beneficiary (or to the estate of an employee) on or after the employee's death (IRC section 72[t][21[A][ii]);
* attributable to the taxpayer becoming disabled, within the meaning of IRC section 72(m)(7) (IRC section 72[t][A][iii]);
* part of a series of substantially equal periodic payments--not less frequently than annually--made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and a designated beneficiary ([RC section 72[t][A][iv]);
* made to an employee after separation from service after the age of 55 (IRC section 72[t][A][v]);
* made on account of a levy under IRC section 6331 on the qualified retirement plan (IRC section 72[t][A][vii]);
* made to the employee for amounts paid during the taxable year for medical care, determined without regard to whether the employee itemized deductions for that taxable year (IRC section 72[t][[B]);
* made to alternate payees pursuant to qualified domestic relations orders (1RC section 72[t][C]);
* made to unemployed individuals for health insurance premiums (IRC section 72[t][D]);
* made from individual retirement plans for higher education expenses, not to exceed the amount of those expenses (IRC section 72[t][E]);
* made from certain plans for first-time home purchases less than or equal to $10,000 (IRC section 72[(t][F]); or
* made to individuals called to active duty (IRC section 72[t][G]).
All of the 10% penalty exceptions described above apply to 401(k) and 403(b) plans; however, those exceptions related to qualified domestic relations orders and separation from service after attaining age 55 do not apply to IRAs (IRC section 72[t][A]).
The substantial limitations placed upon many of the exceptions to the premature distribution penalty might be too restrictive for the average taxpayer and can limit planning opportunities (i.e., many of the provisions specify the exact use available for the distributed funds, such as medical care, medical insurance premiums, higher education expenses, and purchase of a first home). These exceptions work well if the taxpayer falls into one of these narrowly defined categories, but taxpayers might need a distribution to pay for current expenses that do not fall into any of these exceptions. In such cases, tax advisors should consider the SEPP, which offers a wider range of planning opportunities.
Methods for Calculating the SEPP
Payments are considered to be SEPP if they meet one of the following three payment methods:
* The RMD method (Revenue Ruling 2002-62 section 2.01[a] under Internal Revenue Bulletin 2002-42)
* The fixed amortization method (Revenue Ruling 2002-62 section 2.01[b])
* The fixed annuitization method (Revenue Ruling 2002-62 section 2.01[c]).
The sections below demonstrate how the periodic payments are calculated under each method for payment in the first through fifth year, they also compare and contrast the payment amounts.
Under the RMD method, the amount of the periodic payment is determined by dividing the account balance by the life expectancy taken from the chosen life expectancy table for the year. The account balance can be determined in a reasonable manner based upon a taxpayer's specific facts and circumstances (Revenue Ruling 2002-62 section 2.01[d]). In Revenue Ruling 2002-62, the IRS indicated that a reasonable account balance for the first-year distribution could equal the account value on any day between the prior year's end (December 31) and the date of the first-year distribution. A reasonable account balance for subsequent years would include the balance on December 31 of the prior year or on a date within a reasonable period before that year's distribution. For ease of computation, taxpayers often use the prior year-end (December 31) balance; a year-end statement for the account easily substantiates this amount. Taxpayers also receive Form 5498, IRA Contribution Information, providing the fair market value balance of the account on December 31 of the prior year, from the plan administrator or custodian (IRS instructions to Form 5498 and Form 1099R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts).
The allowable life expectancy tables for the RMD method include the following:
* The uniform lifetime table in Appendix A of Revenue Ruling 2002-62 section 2.01(a)
* The single life expectancy table in Treasury Regulations section 1.401(a)(9)9, Q&A 1 (Revenue Ruling 2002-62 section 2.01[a])
* The joint and last survivor table in Treasury Regulations section 1.401(a)(9)9, Q&A 3 (Revenue Ruling 2002-62 section 2.01[a]).
Once a life expectancy table is selected, a taxpayer must continue to use the same table in subsequent years (Revenue Ruling 2002-62 section 2.01[a]). For purposes of the tables, age is determined on the taxpayer's birthday in the year of distribution (Revenue Ruling 2002-62 section 2.01[a]). For each subsequent year, the taxpayer's life increases one year for purposes of the life expectancy tables (Revenue Ruling 2002-62 section 2.01[a]).
The uniform lifetime table is a non-gender-based table created by the IRS to simplify minimum distribution calculations; it can be used by all taxpayers, regardless of marital status or beneficiary selection. This table attempts to calculate joint survivorship, but it does not use the beneficiary's age in the calculation.
The single life expectancy table is also a non-gender-based table created by the IRS. Because this table is based solely upon a participant's life expectancy, the beneficiary's age is not relevant for the calculation. This table can likewise be used by all taxpayers, regardless of marital status or beneficiary selection.
Finally, the joint and last survivor life expectancy table, another non-gender-based table created by the IRS, is used to calculate joint survivorship payments. Because this table is based upon joint life expectancy, a participant's life expectancy and the age of the beneficiary are relevant to the calculation. In order to use this table, a taxpayer must be married; however, married taxpayers are not required to use this table and can choose the other qualifying tables.
Several rules apply if the joint and last survivor table is selected (Revenue Ruling 2002-62 section 2.01[b]). In order to use this table, the beneficiary used for the calculation must be named as such on a taxpayer's account as of January 1 of the distribution year; if there are multiple beneficiaries, the designated beneficiary for purposes of IRC section 401(a)(9) will be used (Revenue Ruling 2002-62 section 2.01[b]). The designated beneficiary is generally the oldest beneficiary named. The ages of both the taxpayer and the designated beneficiary on their birthdays in the distribution year are used for the life expectancy tables (Revenue Ruling 2002-62 section 2.01[b]).
If both the taxpayer and the beneficiary are still alive in subsequent years, their ages will increase by one year on their birthdays; however, if the beneficiary dies during the current year, the beneficiary's age on his birthday in the year of death is taken into account, even if his death occurs prior to the distribution date (Revenue Ruling 2002-62 section 2.01[b]). In any year where no beneficiary has been designated or the designated beneficiary died in the prior year and the taxpayer has not named a new beneficiary, the taxpayer must use the single life expectancy table (Revenue Ruling 2002-62 section 2.01[b]). As indicated earlier, the beneficiary must be the named beneficiary on January 1 of the distribution year in order to use the joint and last survivor tables.
Example. Assume that taxpayer Nicole Smith has an account balance of $500,000 on December 31 of the year prior to the first distribution. Smith turned 50 years old during the year in which the first distribution was made. She named her spouse, who was 43 years old in the year that the first distribution was made, as the designated beneficiary on her retirement account. Assume that a reasonable interest rate is 2% (an example with a 4% rate will be provided later) for the first five distribution years (i.e., 120% of the federal midterm rate). The IRA account balance on December 31 of the year prior to the second, third, fourth, and fifth distributions is assumed to be $500,000 for purposes of the following calculations; thus, it is assumed that the rate of return on the account is equal to the withdrawal rate.
Using this fact pattern, one can calculate the SEPP amount under the RMD method using each of the three allowable life expectancy tables.
The following is the SEPP calculation using the uniform lifetime table:
* Formula: account balance / life expectancy from uniform lifetime table = RMD
* First-year distribution: $500,000 / 46.5 = $10,753
* Second-year distribution: $500,000 / 45.5 = $10,989
* Third-year distribution: $500,000 / 44.6 = $11,211
* Fourth-year distribution: $500,000 / 43.6 = $11,468
* Fifth-year distribution: $500,000 / 42.6 = $11,737
The following is the SEPP calculation using the single life expectancy table:
* Formula: account balance / life expectancy from single life expectancy table = RMD
* First-year distribution: $500,000 / 34.2 = $14,620
* Second-year distribution: $500,000 / 33.3 = $15,015
* Third-year distribution: $500,000 / 32.3 = $15,480
* Fourth-year distribution: $500,000 / 31.4 = $15,924
* Fifth-year distribution: $500,000 / 30.5 = $16,393 The following is the SEPP calculation using the joint and last survivor life expectancy table:
* Formula: account balance / life expectancy from joint and last survivor table = RMD
* First-year distribution: $500,000 / 44.4 = $11,261
* Second-year distribution: $500,000 44.1 = $11,338
* Third-year distribution: $500,000 / 43.8 = $11,415
* Fourth-year distribution: $500,000 / 43.6 = $11,468
* Fifth-year distribution: $500,000 / 43.3 = $11,547
See Exhibit 1 for a comparison of the SEPP amount calculated using the R MD method for each of the three tables described above.
EXHIBIT 1 Substantially Equal Period Payment (SEPP) Amounts Using All Three Lite Expectancy Tables under the Required Minimum Distribution (RMD) Method Year RMD Uniform Life RMD Single Life RMD Joint Life Table Table Table Year 1 $10,753 $14,620 $11,261 Year 2 $10,989 $15,015 $11,338 Year 3 $11,211 $15,480 $11,415 Year 4 $11,468 $15,924 $11,468 Year 5 $11,737 $16,393 $11,547
Fixed Amortization Method
Another method for calculating the SEPP is the fixed amortization method, under which the account balance is amortized over the life expectancy taken from the selected life expectancy table at a reasonable rate of interest. The interest rate that may be used is any interest rate less than 120% of the federal midterm rate, determined in accordance with IRC section 1274(d), for either of the two months immediately preceding the month in which the distribution begins (Revenue Ruling 2002-62 section 2.01[c]).
Example. Using the same fact pattern as above, one can calculate the SEPP under the fixed amortization method.
The following is the calculation for the SEPP under the uniform lifetime table:
* Formula: account balance is amortized over the life expectancy taken from the uniform lifetime table at the chosen interest rate
* $500,000 amortized over 46.5 years at 2% = $16,617 for all years
* $500,000 amortized over 46.5 years at 4% = $23,850 for all years
The following is the calculation for the SEPP under the single life expectancy table:
* Formula: account balance is amortized over the life expectancy taken from the single life expectancy table at the chosen interest rate
* $500,000 amortized over 34.2 years at 2% = $20,326 for all years
* $500,000 amortized over 34.2 years at 4% = $27,082 for all years
The following is the calculation for the joint and last survivor life expectancy table:
* Formula: account balance is amortized over the life expectancy from the joint and last survivor life expectancy table at the chosen interest rate
* $500,000 amortized over 44.4 years at 2% = $17,097 for all years
* $500,000 amortized over 44.4 years at 4% = $24,251 for all years
The Fixed Annuitization Method
The final method for calculating the SEPP is the fixed annuitization method, under which the payments are determined by dividing the account balance by 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) using the chosen interest rate.
Example. Using the same fact pattern as the prior examples, one can calculate the allowable SEPP under the fixed annuitization method.
The annuity factor, derived from the mortality tables in Appendix B of Revenue Ruling 2002-62 for an individual who is 50 years old and has chosen an interest rate of 2%, is 24.6828; with an interest rate of 4%, it is 18.5970. Under each of the tables--the uniform lifetime table, the single life expectancy table, and the joint and last life expectancy table--the annuitization calculation is the same amount, as follows:
* Formula: the account balance is divided by the present value of the annuity factor for 2% ($500,000 / 24.6828 = $20,257 for all years)
* The account balance is divided by the present value of the annuity factor for 4% ($500,000 / 18.5970 = $26,886 for all years)
See Exhibit 2 and Exhibit 3 for a comparison of the SEPP amount calculated under the fixed amortization and fixed annuitization methods, using a 2% interest rate and a 4% interest rate, respectively. A few observations can be drawn from all three exhibits. If the taxpayer wants to maximize the available payout, the fixed amortization method or the fixed annuitization method should be selected. Exhibit 2 and Exhibit 3 demonstrate that the higher the chosen rate, the higher the SEPP. The amount allowed under the RMD method will change each year because the account balance and life expectancy factor will also change. It is important to note that the annual payments under the fixed amortization method and the fixed annuitization method remain constant throughout the required payment period.
EXHIBIT 2 Substantially Equal Period Payment (SEPP) Amounts Using All Three Life Expectancy Tables under the Fixed A mortization and Fixed Annuitization Methods (Interest Rate = 2%) Year Fixed Fixed Fixed Fixed Amortization Amortization Amortization Annuitization Uniform Life Single Life Joint Life All Tables Table Table Table Year 1 $16,617 $20,326 $17,097 $20,257 Year 2 $16,617 $20,326 $17,097 $20,257 Year 3 $16,617 $20,326 $17,097 $20,257 Year 4 $16,617 $20,326 $17,097 $20,257 Year 5 $16,617 $20,326 $17,097 $20,257 EXHIBIT 3 Substantially Equal Period Payment (SEPP) Amounts Using All Three Life Expectancy Tables under the Fixed Amortization and Fixed Annuitization Methods (Interest Rate = 4%) Year Fixed Fixed Fixed Fixed Amortization Amortization Amortization Annuitization Uniform Life Single Life Joint Life All Tables Table Table Table Year 1 $23,850 $27,082 $24,251 $26,886 Year 2 $23,850 $27,082 $24,251 $26,886 Year 3 $23,850 $27,082 $24,251 $26,886 Year 4 $23,850 $27,082 $24,251 $26,886 Year 5 $23,850 $27,082 $24,251 $26,886
General SEPP Requirements and Payment Modification Rules
Once initiated, the SEPP method must continue for either five years or until the taxpayer reaches age 59 1/2, whichever occurs later (IRC section 72[t]). Modifications to the SEPP will result in the disqualification of the payment as an allowable exception to the 10% premature penalty. Interest and the penalty will be calculated from the due date of the return until they are paid in full. A taxpayer who discovers that a payment has been modified should bring this to the IRS's attention; failure to do so may result in additional penalties, such as the substantial underpayment or fraudulent return penalties.
The following changes in the amount of the payment have been held not to be modifications resulting in disqualification of the periodic payment:
* The taxpayer's assets in the individual account plan or an IRA are exhausted (Revenue Ruling 2002-62 section 2.03[a]).
* A taxpayer who is using the fixed amortization method or the fixed annuitization method makes a one-time change to the RMD method (Revenue Ruling 2002-62 section 2.03[b]).
* The taxpayer becomes disabled (IRC section 72[t] [3D.
* The taxpayer dies (IRC section 72[t]).
* The taxpayer experiences a divorce (Private Letter Ruling [PLR] 2000-50046).
Although the fixed amortization method and the fixed annuitization method under Revenue Ruling 2002-62 indicate that, once calculated, the payment amount is fixed for the duration of the SEPP, at least four PLRs have allowed for annual recalculation (PLRs 200432021, 200432023, 200432024, and 200532062). PLR 200503036 indicated that a make-up payment in the current year for an underpayment in the prior year that resulted from a mistake made by the financial institution was not considered to be a modification.
PLRS are only applicable to the individual who requested the ruling; however, they do give some indication of the government's position on a topic. If a taxpayer wants to have some certainty regarding the IRS treatment of a transaction prior to completing it, the time and cost ($2,500 to $5,000) of securing such a ruling might be worth the resulting peace of mind.
Which options are available to taxpayers who have multiple accounts? If a taxpayer only has one account, the SEPP must amortize the entire account balance. If the taxpayer has several accounts, the SEPP does not require the aggregation of the accounts; rather, it only requires the amortization of one account. The account selected for the SEPP must be fully amortized; the taxpayer cannot amortize less than the full amount in the account. Thus, if the taxpayer wants to shoot for a specific target SEPP, an IRA should be split into two or more IRA accounts and the taxpayer should amortize the account that results in the desired SEPP amount. The taxpayer can choose to aggregate one or more accounts in determining the SEPP.
The IRS has allowed the SEPP to come from one, several, or all of the aggregated accounts (PLR 9816028). This would allow a taxpayer with separate IRA accounts set up for each child and each grandchild to not only aggregate accounts in order to increase the amount of lifetime SEPP but also to allow for actual withdrawal from the accounts with the shortest life expectancies (PLR 9816028). This would allow the account owner to take select distributions from his children's accounts without depleting his grandchildren's accounts. Stretching the payout to grandchildren over their life expectancies could generate astonishing cumulative distributions, resulting in a major transfer of wealth to this younger generation (PLR 200811028).
For example, assume a taxpayer leaves a $100,000 IRA to her 10-year-old grandchild, who earns a 2%, 4%, or 6% return on the funds in the plan. If the grandchild earns a 2% return, he withdraws $232,398 over his life expectancy. If the grandchild earns a 4% return, the amount withdrawn over his life expectancy increases to $626,645. Finally, with a modest 6% rate of return, the grandchild withdraws an astonishing $1,876,425 over his life expectancy.
IRS Reporting Requirement
There might not be any reporting required by the taxpayer, depending upon how the plan administrator or custodian reports the distribution. If the plan administrator reports the distribution on a Form 1099-R and indicates that the distribution on line 7 qualifies for an exception to the premature distribution penalty, no further reporting is required from the taxpayer; however, if the plan custodian or administrator reports the distribution on *the Form I 099-R line 7 as either a distribution code 1 for an early distribution (for which no exception applies) or a distribution code 7 for a normal distribution, additional reporting will be required. In this case, the taxpayer will be required to attach IRS Form 5329, Additional Taxes on Qualified Plans, to the tax return and fill out part 1 line 2 for early distributions qualifying for an exception (IRS Form 5329 and Instructions).
Advantages of the SEPP Rules
There are many advantages to the SEPP method of avoiding the premature withdrawal penalty. This method is not nearly as restrictive as many of the other available methods of avoiding the penalty; a taxpayer must specifically qualify for the other narrowly drafted exceptions. The SEPP method is flexible, allowing for variation in the amounts that can be distributed--from vely small wider the RMD method to very large under the fixed methods. By using the joint and survivor life expectancy table and the RMD method, an account owner can stretch out payments to younger family members, thus transferring vast amounts of wealth over the years, as well as providing retirement savings to the younger generation. In addition, the taxpayer can take advantage of PLRs prior to making the first SEPP, in order to ensure that the payments will qualify and that the taxpayer will avoid the premature withdrawal penalty.
Disadvantages of the SEPP Rules
Although the SEPP method offers numerous advantages, it can also present several disadvantages that taxpayers and their advisors should keep in mind. A taxpayer must correctly determine the amount of the qualifying payment each year. The IRS advice in Revenue Ruling 2002-62 only deals with annual payments, not more frequent than quarterly or monthly payments. And after the selection of a SEPP method, modification of the payments is severely limited.
In addition, the use of the fixed methods, resulting in large payouts, might exhaust the retirement account prior to the taxpayer's death. Changes in named beneficiaries under the RMD method must be closely observed to ensure that an improper distribution is not made during the year, thus resulting in a modification to the SEPP. Even though PLRs are available for SEPPs, they require substantial costs, including time, filing fees, and accounting or legal fees. Taxpayers might be subject to additional reporting requirements in order to meet the SEPP exception. Finally, even though the SEPP can be structured to avoid the penalty for early withdrawal, the payment is still subject to federal income tax.
Planning Opportunities for SEPP
Taxpayers who do not neatly fall into one of the other exceptions to the premature distribution penalty rules should explore the SEPP provisions, which provide a flexible method of withdrawing significant amounts from IRAs without imposition of the 10% premature distribution penalty. When making the SEPP decision, taxpayers and their advisors should consider that payments must be made for the duration of the required payment period, only limited modification to the payment amount is available, and the money withdrawn will not be available for retirement.
The ability to stretch payout after the death of the account owner and over the life expectancies of younger beneficiaries is also attractive. A taxpayer with these specific goals will likely find that the flexibility of the SEPP provisions is a very useful tool for removing significant amounts of money from a retirement plan without incurring the premature distribution penalty. But taxpayers and their advisors must remember that, although SEPP provisions do offer great flexibility, they are not without their own pitfalls. The limitation on payment modification, possible exhaustion of plan assets, income taxation of the distribution, and potential penalties for disqualification must be taken into account to determine whether the SEPP provisions are right for a particular taxpayer.
RELATED ARTICLE: ONLINE RESOURCES
Any tax advisor recommending the substantially equal periodic payment (SEPP) method should be able to manually calculate all of the allowable SEPP options. For that reason, examples of each method with step-by-step calculations are provided in this article. But online financial calculators can also perform the SEPP calculations; tax advisors can use these to double-check their own results. The following are some of the resources available to tax advisors:
* Lincoln Financial Group (http://www.lfg.com/LincolnPageServer?LFGPage=/lfg/lfgclient/plntls/fincal/calc1/index.html&LFGContentID=/lfg/lfgclient/plntls/fincal/calc1/retire72alt)
* New York Life (http://www.newyorklife.com/newyorklife.com/General/FileLink/Statie%20Files/file/other/RetireDistrib.html)
* BB&T Funds (http://www.bbtfunds.com/education/calculators/72t.aspx)
* Mass Mutual Financial Group (http://www.massmutual.com/mmcalcs/Retire72T.html)
* Bankrate.com (http://www.bankrate.com/calculators/retirement/72-t-calculator.aspx)
* Dinkytown.net (http://www.dinkytown.net/java/Retire72T.html)
Tracey A. Anderson, JD, LLM, CPA (Ariz., Ind.), is a professor of accounting at Indiana University South Bend. He is also licensed as an attorney in Arizona, Indiana, and Michigan.
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|Title Annotation:||personal financial planning|
|Author:||Anderson, Tracey A.|
|Publication:||The CPA Journal|
|Date:||Jun 1, 2013|
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