Do you have clients younger than age 59½, need additional income and want to withdraw assets from a former employer's retirement plan but are concerned about the 10-percent tax penalty on premature distributions?
With the recent wave of corporate downsizing, there is a good chance a number of your clients are in this situation. Roughly 4.1 million American jobs have been eliminated within the past 12 months, according to the U.S. Department of Labor. As a result, millions of Americans are either changing jobs or being forced into early retirement and looking for a way to generate extra income.
Fortunately, there is a potential solution that can help you meet your clients' needs and the needs of potential referrals who may be in a similar situation. Internal Revenue Code (IRC) Sections 72(t) and 72(q) allow individuals to withdraw tax-deferred assets prior to age 59½ -- exempt from the 10-percent federal tax penalty on premature distributions.
IRC Sections 72(t) and 72(q)
IRC Sections 72(t) for qualified plans and 72(q) for non-qualified annuities, allow an exception to the 10-percent federal tax penalty if distributions are taken as part of a series of substantially equal periodic payments (SOSEPP). The IRS provides specific guidelines on how the SOSEPP payments need to be taken: Failure to abide by these guidelines may subject your client to the 10-percent premature distribution penalty on all prior distributions if they fail to follow the rules.
The IRS requires that distributions must be made at least annually and continue for the greater of five years or the attainment of age 59½. Distributions must be based on the life expectancy of the recipient, and the maximum earnings rate assumption is based on the midterm applicable federal rate. In addition to these requirements, the IRS offers three calculation methods that are permitted in determining the SOSEPP: the required minimum distribution (RMD)/ life expectancy method, the amortization method and the annuitization method.
When counseling clients who are considering a 72(t) or 72(q) distribution, there are several factors to consider. Because the SOSEPP must continue for the greater of five years or the attainment of age 59½, clients who are aged 57 or 58 may want to weigh the impact of the 10-percent federal tax penalty on premature withdrawals made within the next two years versus the tax liability of continuing distributions for five years. If your client anticipates a temporary need, paying the 10-percent federal tax penalty may be advantageous when compared to a five-year commitment to a taxable stream of income that will reduce remaining retirement savings.
Changing the calculation method
The IRS also permits a one-time adjustment in the calculation method down to the RMD method. Since the RMD method pays the lowest SOSEPP, it is important to keep this option in mind if and when your client no longer needs the income provided by the 72(t) or 72(q) distribution. Because your clients are committed to continuing the payments for the greater of five years or the attainment of age 59½, reducing the SOSEPP will minimize the taxable distributions they will continue to receive.
Keeping in mind the idea of minimizing taxable distributions, it's important to remember that no material modifications of the account (i.e., additions or subtractions) can occur during the course of the 72(t) or 72(q) distributions. Therefore, instead of committing the entire account balance of an IRA to a 72(t) distribution, you may want to consider a partial rollover to a separate IRA for the minimum amount required to satisfy the client's income needs under the 72(t) fixed amortization method. Doing this will allow the remaining IRA account to be used for additional emergency withdrawals or as a vehicle for consolidating other IRA or qualified plan assets.
Frequently asked questions
Since no one can predict the future, you can provide a great deal of flexibility for your clients and help accommodate their changing circumstances by setting up a 72(t) or 72(q) distribution. However, there are a number of important guidelines that must be followed in order to realize the greatest tax advantages. Let's address some common questions that often arise when employing this early distribution strategy.
Q: Do All IRA accounts have to be combined to determine the amount of the distribution?
Individual retirement plans do not have to be aggregated for purposes of calculating these payments. If a taxpayer owns more than one IRA, any combination of the taxpayer's IRAs may be taken into account in determining the distributions by aggregating the account balances of those IRAs. *(Private Letter Rulings (PLR) 200309028 and 9050030)
Q: If the individual includes more than one account, which accounts do they use to make the payments?
If two or more IRAs are used in determining the series of substantially equal periodic payments, the distributions need not be made from all of the included IRA accounts. The distributions may be made solely from one of the accounts, or from a combination of the accounts. (PLR 9705033)
Q: If the individual gets divorced and transfers a portion of the payments to their ex-spouse, will the exemption from the 10-percent federal penalty tax be lost?
In PLR 200027060, the IRS ruled that after a divorce, an individual who received a portion of his or her ex-spouse's IRA accounts that were being used to fund a SOSEPP need not continue the payments since it was a transfer under Code Section 408(d)(6).
Q. What about the spouse? Would all of the payments have to be continued out of what remained of his or her accounts?
Later, in PLR 200050046 (with similar facts), the IRS ruled in favor of the taxpayer. The ruling states: "The reduction in the annual distribution from IRA 1 to Taxpayer A beginning in calendar year 2001, prior to Taxpayer A's attaining age 59 1/2, and assuming Taxpayer A has not died and has not become permanently disabled, will not constitute a subsequent modification in his series of periodic payments, as the term 'subsequent modification' is used in Code section 72(t)(4), and will not result in the imposition upon Taxpayer A of the 10 percent additional income tax imposed by Code section 72(t)(1) pursuant to Code section 72(t)(4)(A)(ii)."
Q: What if the individual dies or becomes disabled?
If the individual dies after they begin receiving payments, the proceeds of his or her retirement plan will be exempt from the 10-percent federal penalty tax and retroactive interest. The beneficiaries will receive their retirement assets penalty-free and will not be required to continue with the plan. In addition, if the individual becomes permanently disabled before satisfying plan requirements, the penalty tax and the retroactive interest provision do not apply.
Q: If an individual is taking 72(t) distributions from a traditional IRA and decides to convert it to a Roth IRA, is that considered a "material modification" subject to penalties?
If an individual is receiving a series of substantially equal periodic payments (72t) from a traditional IRA and converts the traditional IRA to a Roth IRA, the conversion is not treated as a distribution for purposes of determining whether a material modification has occurred. The conversion itself does not trigger the loss of the 72(t) distribution (Treas. Reg. 1.408A-4, A-12).
However, the conversion does not mean that the participant can stop taking his periodic payments. The same payments must continue for the original five years or age 59 ½ timeframe, whichever is longer.
Q: What if the individual elects the one-time option of switching to the life expectancy (RMD) method in midyear, after they have already taken out more money than would be required under the new, lower calculation?
In PLR 200419031, the IRS allowed a participant in this situation to roll back the excess payments into the IRA so that his or her net distribution for the year would comply with the newly elected RMD method.
Q. What if my client runs out of money?
Revenue Ruling 2002-62 allows plans that run out of funds not to incur the 10-percent federal penalty tax. Section 2.03(a) states: "If, as a result of following an acceptable method of determining substantially equal periodic payments, an individual's assets in an individual account plan or an IRA are exhausted, the individual will not be subject to additional income tax under 72(t)(1) as a result of not receiving substantially equal periodic payments and the resulting cessation of payments will not be treated as a modification of the series of payments."
Finally, because of the importance of satisfying the requirements and calculating the SOSEPP, you would benefit from working with a company that can provide turnkey administration for you and your clients. Look for a company that will calculate the required payment amount under the three available distribution methods, provide you with a personalized illustration that can be shared with your client and code the distributions accordingly on your client's 1099 tax form.
In this era of corporate downsizing and plan terminations, many individuals are looking for someone to help them navigate the complex IRS guidelines and the myriad rules and requirements that apply to retirement income distributions. By providing expert guidance and a reliable solution, you will be providing a valuable service to clients who are seeking assistance during a challenging time.
Note: The opinions and forecasts expressed are those of Jason Ryan as of March 20, 2009, any may actually not come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation.
An annuity is a long-term, tax-deferred investment designed for retirement. Earnings are taxable as ordinary income when distributed and, if withdrawn before age 59½, may be subject to a 10 percent federal tax penalty. Variable annuities involve investment risks and may lose value
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Annuities and life insurance are issued by Jackson National Life Insurance Company (Home Office: Lansing, Michigan) and in New York, annuities are issued by Jackson National Life Insurance Company of New York (Home Office: Purchase, New York). Variable products are distributed by Jackson National Life Distributors LLC. May not be available in all states and state variations may apply. These products have limitations and restrictions. Contact the Company for more information.
As required by the IRS, you are advised that any discussion of tax issues in this material is not intended or written to be used, and cannot be used, (a) to avoid penalties imposed under the Internal Revenue Code or b) to promote, market or recommend to another party any transaction or matter addressed herein.
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