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Substantially Equal Periodic Payments

IRC Sec. 72t

Withdrawals Penalty-Free

1.   Are you under 59½ years of age and considering an early retirement?

 

2.   Have you sheltered savings in an employer-sponsored retirement plan?

 

3.   Will you need monthly income from your IRA or Qualified Retirement Plan (QRP) after retirement?

4.   Have you put your retirement on hold because of possible penalties associated with early withdrawals from IRAs and QRPs?

If the answer to these questions is yes, then your dilemma may be solved.  Rule 72t (found in IRC Sec. 72t(2)(A)(iv), substantially equal periodic payments, and modified under Revenue Ruling 2002-62), allows IRA owners and QRP participants under 59½ years of age to withdraw predetermined amounts from their IRA or QRP over a required period of time and avoid the premature distribution penalty.  Ordinary income tax rules will apply.  Payments for QRP participants may not begin until separation from service.

NOTE: The 10% premature distribution penalty is waived for QRPs when the participant has separated from service after reaching age 55.

Background

Generally, distributions taken from an IRA or QRP are taxed as ordinary income.  And, if the individual is under age 59½ (or 55 and separated from service for a QRP), a 10% penalty is assessed to the amount withdrawn.  However, there are several exceptions to the penalty rule, such as death, disability, first-time homebuyer, higher education, and an exception commonly known as Rule 72t.

The Program

IRA owners and QRP participants receive predetermined income distributions based on their life expectancy, through a scheduled series of periodic payments (not less frequently than annually) that continue unaltered over a specified period of time.

Payment period

The specified period for payments is either 5 years or until the participant reaches age 59½, whichever is longer.

For example: If an IRA owner turns age 50 and begins taking substantially equal periodic payments, that individual must continue payments until reaching age 59½ (9-plus years). If an IRA owner is 58 when payments begin, that individual must continue payments for 5 full years (until age 63)

          Note: The 5-year rule is waived at death or disability and the program ends. 

 

Structuring of payments

There are three methods suggested by the Internal Revenue Service (IRS Notice 89-25) to determine payments that will qualify as ”substantially equal periodic payments based on life expectancy,” which are:

Method 1: Required minimum distributions (RMDs)

Using this method, payments are determined by dividing the individual's IRA or QRP balance by their single life expectancy factor, or a joint factor of the individual and the primary beneficiary.  The factor to be used is selected from the single life expectancy table, the joint life expectancy table, or the uniform lifetime table.  Once a table is selected, that same table must be used to determine each subsequent year’s distribution.  The account balance that is used to determine payments must be determined in a reasonable manner based on the facts and circumstances.

Example:  An individual intends to begin taking distributions on July 1, and has an IRA that is valued daily.  It would be reasonable to determine that the first distribution may be based on the value of the IRA on any day from December 31 of the previous year to July 1.  In this example, the individual decides to use his December 31 balance of $100,000.  He is single and will turn age 50 in the year of the first distribution.  Using the Single Life Expectancy Table, found in the 2002 IRS Supplement to Publication 590, he determines that his single life expectancy is 34.2 years.  His payment is calculated by dividing $100,000 by 34.2, resulting in an annual payment of $2,923.98.  For subsequent years, the individual will “recalculate” each year’s payment by using the IRA value on December 31 of the prior year, or a date within a reasonable period before that year’s distribution, divided by the newly determined life expectancy factor again found in the Single Life Expectancy Table.

          Method 2: Fixed amortization

The payments under method 2 are determined by amortizing the IRA or QRP balance over the single life expectancy of the individual, the joint life expectancy of the individual and the designated beneficiary, or the life expectancy found in the uniform lifetime table.  Any interest rate that is not more than 120% of the federal mid-term applicable federal rate, determined on the date payments begin, may be used.

Example: An individual is 50 years old and has a balance of $100,000 in his IRA on the day he intends to take his first distribution.  He determines that 120% of the mid-term applicable interest rate is 2.71%.  Factoring in the 2.71% rate of return and a single life expectancy of 34.2 years, the calculated annual payment will be $4,522 per year over the scheduled period of distributions (subsequent year’s payments are not recalculated).

          Method 3: Fixed annuitization

A third alternative is to divide the IRA or QRP balance by an annuity factor.  The factor is determined based on the present value of an annuity of $1 per year beginning at the individual's age attained in the first distribution year and continuing for the life of the individual. This factor is determined by using an interest rate of 120% of the mid-term applicable federal rate on the date payments begin.

Example: Using 2.71% as the interest rate of return and the single life mortality table, a 50-year-old IRA owner with a $100,000 balance would receive annual distributions of $4,507 per year, over the scheduled period of distributions (subsequent year’s payments are not recalculated).

To calculate payments using Method 3, a tax advisor or an actuary must provide the appropriate annuity factor table.

Changes to account balance

Under all three methods, 72t payments are calculated with respect to the account balance established prior to the first 72t payment.  This means that a modification to the 72t program will occur if, after the starting date, there is:

 

·Any additions to the current account balance other than gains or losses;

 

·Any nontaxable transfer of a portion of the account balance to another retirement plan; or

 

·A rollover by the taxpayer of a 72t payment received resulting in such amount not being taxable.

 

Existing 72t program relief

Once a 72t payment schedule was established and payments began, the series of payments could not be modified in any way. If they were modified (other than by reason of death or disability), the 10% early distribution penalty tax, plus interest, would be applied retroactively, beginning with the first distribution.  However, Ruling 2002-62 was introduced to provide relief:

1.    If, as a result of following an acceptable method of determining substantially equal periodic payments, the assets in an individual account plan or IRA are exhausted, and the payments cease, no additional income tax or penalties will be due.

 

2.    Taxpayers who have an existing 72t program and are using the “fixed amortization” or the “fixed annuitization” method to compute their payments may switch to the “required minimum distribution” (RMD) method.  The change in method will not be considered a “modification,” thus no penalties or interest will apply.  This switch is a one-time only option and is irrevocable.

Questions and Concerns

Q.      What interest rate may be used for the “fixed amortization” or “fixed annuitization”       methods of calculations?

A.           The interest rate that may be used is any interest rate that is not more than 120% of the federal mid-term rate (determined for either of the two months immediately preceding the month in which the distributions begin).  The “Index of Applicable Federal Rates” may be found at: http://www.irs.gov/app/picklist/list/federalRates.html

Q.      How do I determine my balance for my first distribution?

A.           The balance to be used must be determined in a reasonable manner based on the facts and circumstances.  It would be reasonable to determine the yearly account balance based on the value of the IRA on any day from December 31 of the prior year to the date that the first distribution will occur. 

Q.      Does an individual who has more than one IRA or QRP have to include all IRA and QRP balances in the program?

A.      It is not necessary to take distributions from other IRAs or QRPs or to consider their balances when determining substantially equal periodic payments (Private Letter Ruling (PLR) 8946045). *

Q.           I have selected the “required minimum distribution” method for my 72t program and have determined my first distribution.  What balance will I use for subsequent payments?

A.           It would be reasonable to use the value either on December 31 of the prior year or on a date within a reasonable period before that year’s distribution.

Q.           When using one of the three methods suggested by the IRS to determine payments, which life expectancy table must I use to determine my distribution?

A.           An individual may choose from one of three tables to determine their distribution:

1.           The uniform lifetime table – This table projects the life expectancy period using the age of the participant and assumes a beneficiary that is 10 years younger.

2.           The single life expectancy table – This table projects the life expectancy period based on the participant’s age only. 

3.           The joint and last survivor table – This table projects the life expectancy period based on the actual ages of the participant and the oldest person named as a beneficiary.

Q.      Must payments be structured over a calendar year, or may an alternate 12-month period be used?

A.      In PLR 9021058, an individual was allowed to use the 12-month period from December 15 to December 14.  It appears an annual measuring period other than a calendar year may be used. *

Q.      May payments in the first year be based on the number of months remaining in that year?

A.      Yes, the first year’s payments may be based on the number of months remaining.  In PLR 9049044, the IRS allowed an IRA owner to pro rate the first payment rather than take a payment based on a full year. *

Q.      Once substantially equal periodic payments begin, can additional distributions (in excess of the structured payments) be taken from the same account, provided the 10% early distribution penalty is paid?

A.      No, any additional distributions exceeding the structured payment amount would be viewed as a modification of the payment schedule.  The 10% early distribution penalty would be assessed retroactively.

*Private Letter Rulings may only be relied upon by the person who requested that ruling,

  and oral interpretations from the IRS cannot be relied on as authoritative guidance.

Penalty-free means playing by the rules

If you retire early and want to take withdrawals from an IRA or QRP prior to age 59½, one way you can avoid paying the 10% premature distribution penalty tax is by taking substantially equal periodic payments. However, qualifying for this exception is complicated, and it's important that you understand and follow all the rules.

Stifel Nicolaus Can Help

Your Stifel Nicolaus Financial Advisor and the Stifel Nicolaus Retirement Plan Services Department are well educated in the substantially equal periodic payment program and can offer expertise to you. In addition, Stifel Nicolaus can help you determine if the 72t program will help you pursue your retirement income needs and goals.

Contact your Stifel Nicolaus Financial Advisor for additional information today.  

This information is from sources believed to be reliable, but its accuracy is not guaranteed.  All material and hypothetical examples are for educational purposes only, and it is always recommended that you seek the aid of a competent tax advisor or tax attorney who may assist you with proper tax advice and guidance.

To better understand your options when taking a distribution under rule 72t please take a minute to order a Rollover Kit.

 

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