Many people do not realize that they can begin taking distributions from their IRAs and qualified employer plan accounts without being subject to the 10% penalty on early withdrawals, even if they are younger than 59 ½ . Several exceptions exist to the rule against taking early distributions, but perhaps the most complicated and least understood is the exception commonly referred to as the “Rule 72(t)” or “Section 72(t)” exception.Section 72(t) refers to a provision of the Internal Revenue Code that permits distributions without penalty in certain allowed amounts to persons who have not reached age 59 ½, provided the withdrawals are made as part of “a series of substantially equal periodic payments.” The basic guidelines governing Section 72(t) distributions are set forth in IRS Revenue Ruling 2002-62. The ruling clarifies and defines what is meant by “a series of substantially equal periodic payments” under section 72(t)(2)(A)(iv) of the Internal Revenue Code. It explains how the payments must be calculated and structured for taxpayers to avoid the early distribution tax that would otherwise be applicable to distributions taken before age 59 ½. Some basic rules about the Section 72(t) exception are as follows:
- Payments must be computed as though they are to continue for the life of the taxpayer, or the joint lives of the taxpayer and the beneficiary of the account, and cannot be discontinued or modified except in limited circumstances. Failure to adhere to this schedule until attaining age 59 ½ or 5 years will result in the IRS assessing a penalty of 10% on all previous distributions plus accrued interest.
- Distributions must be substantially equal in amount. What this means is that once a method for determining the amounts of the payments has been set it cannot be changed or varied every year to suit the taxpayer’s financial needs except under very limited circumstances. As stated above, the method for computing distributions and distribution amounts cannot be discontinued or modified for at least 5 years, or until the taxpayer reaches 59 ½. The IRS only allows the scheduled distribution amounts to be modified in four cases: death, disability, depletion of assets, or to make a one-time change to the “required minimum distribution” method if another method was initially selected.
- There is no minimum age when distributions can start. Substantially equal periodic payments can begin at any age. Theoretically, a taxpayer 30 years of age with a mere $10,000 in an IRA could begin taking distributions without penalty provided the amounts were correctly computed.
- Payments from an employer plan cannot begin until the taxpayer is no longer employed by the employer. This does not apply to IRAs.
The IRS has approved three methods for computing Section 72(t) distributions: a) the “Required Minimum Distribution” (RMD) method; b) the “Fixed Amortization” method; and c) the “Fixed Annuitization” method. All of the methods have their advantages and disadvantages depending on the circumstances of each taxpayer. Before choosing one over the other the taxpayer should always consult with an accountant or tax planning professional to go over the alternatives. Generally, the RMD method is simple, straightforward and seldom challenged by the IRS. The Fixed Amortization Method is favored by many taxpayers because it is flexible in that it allows a range of possible payments depending on the interest rate selected (the IRS specifies the federal mid-term interest rate as the “safe-harbor”). The Fixed Annuitization Method is similar to the Fixed Amortization Method except it allows taxpayers to use any reasonable mortality table to compute the annuity factor, and therefore may be more suitable for taxpayers with special health needs or other special situations.
Section 72(t) permits a one-time change from either the Fixed Amortization Method or the Fixed Annuitization Method to the RMD Method. For example, assume Sam started receiving distributions from his IRA in annual substantially equal periodic payments in 2007 at age 50. His annual payment of $65,809 was originally calculated using the amortization method. Sam would like to use the special rule in Rev. Rul. 2002-62 allowing a one-time change to the RMD method to determine a new annual distribution amount beginning in 2011. For this one-time change in method, Sam will determine an annual distribution amount for 2011 using his IRA account balance on March 31, 2011 ($750,000), and a single life expectancy of 30.5 (obtained from Regulations §1.401(a)(9)-9, Q&A-1, using age 54). Under the new method, the 2011 distribution amount is $24,590 ($750,000/30.5). Sam must use the RMD method to determine the annual distribution amount for subsequent years.
Except for changing to the RMD Method, once a schedule of “substantially equal periodic payments” has been established it may not be modified or discontinued for five years or until the taxpayer has reached age 59 ½, whichever is longer. The IRS takes a very strict approach to these time limits. For example, a taxpayer who begins taking distributions at 50 and wishes to stop 59 ½ must do so immediately after the day they reach 59 ½ (as opposed to January 1 of that year). Any other deviation in timing or amounts of payments could be deemed a modification of the plan. The IRS could retroactively treat all payments as normal discretionary distributions, triggering a substantial tax liability. All methods permit taxpayers some flexibility in choosing the frequency of distributions. Taxpayers can elect to take distributions bi-monthly, quarterly, semi-annually, or even annually. Unless instructed otherwise, custodians will withhold 10% from each distribution. However, the amount of tax withheld from each distribution does not need to be “fixed” over the entire period that distributions are being made. If the taxpayer determines that federal tax withholding is insufficient – or that excess amounts are being withheld – amounts can be changed at any time by submitting a Form W-4P to the custodian.
With more and more baby boomers finding themselves in need of income before age 59½, it is becoming critically important for owners of retirement accounts to understand the rules for avoiding early distribution penalties. Section 72(t) can afford relief to taxpayers who find themselves in need of early distributions. Occasionally taxpayers may have special circumstances which make it necessary or desirable to use alternatives methods for computing distributions. The IRS has indicated that it is willing to consider alternative computation methods, and in those cases, we recommend that a private letter ruling be obtained. Section 72(t) affords some relief for taxpayers in need of early distributions. But the rules are complex and improperly timed, hastily calculated, or ill-advised withdrawals can result in heavy tax liabilities. Before proceeding we always recommend consulting with legal advisors trained in this technical area.
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IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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