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Retirement Perspectives

The IRS allows individuals to withdraw early from their IRAs, providing certain criteria are met and the withdrawal amount is established by one of three sanctioned methods.

Do you have any clients who have large IRA account balances, including SEP and SIMPLE IRAs, and would like to consider an early retirement, or someone who could just use additional income? What stops them from taking the money? It’s fear of the tax consequence of their actions. Most people understand that IRA distributions are taxable and that if distributions are taken before age 59½, individuals are assessed a 10% penalty on the taxable portion of the distribution. (Aftertax dollars are not taxed when distributed and are not subject to a 10% penalty.)

The Internal Revenue Code (IRC) Section 72(t)(2)(A)(iv) permits distributions (often called “Section 72(t)”) from IRAs prior to age 59½ without imposing the 10% premature distribution penalty under the following circumstances:

  • Distributions must be made at least annually for five years or attainment of age 59½, whichever comes later.
  • The distribution amount must be determined under one of three IRS-sanctioned methods outlined in IRS Notice 89-25 and substantiated in Revenue Ruling 2002-62.

What are the three IRS-sanctioned methods?

Method #1 is called the life-expectancy method, or a required minimum distribution (RMD), whereby annual distributions are based on the life expectancy of the account’s owner being divided into the IRA’s value at the time distributions commence. Distributions fluctuate yearly with the account owner’s age and life expectancy, and the value of the IRA also changes.

Method #2 is called the amortization method. Here, the IRA account balance is treated like the mortgage amount due on a home. The IRA is amortized using a fixed interest rate prescribed by IRS regulations over a term equal to the account owner’s life expectancy. (A different [higher] interest rate could be used, but then it would require the account owner to prove the rate selected was reasonable, should the IRS inquire.) Rather than paying a lending institution, as would be done with a mortgage, the IRA pays the account owner. The annual payout is fixed at the time distributions commence and does not vary from year to year. Just as with mortgages, the higher the interest rate is, the larger the payout will be, and the shorter the payout period is, the larger the payout will be.

Method #3 is called the annuity method. It is similar to the amortization method, in that it uses the same interest rate and life expectancy, but then introduces a mortality table prescribed by regulation to pay out the IRA account as if it were an annuity. The annual payout is fixed at the time distributions commence and does not vary from year to year.

Weighing the Choices
Each method is designed to produce substantially equal payments. If an individual elected the amortization or annuity method and used an interest rate that was subsequently deemed not reasonable or if the account owner failed to continue taking the required payments for the requisite time period under any method, the IRS can assess the 10% penalty retroactively to the first year distributions began, as well as impose interest and penalties for tax underpayments.

The life-expectancy method will always produce the lowest annual payment. Results generated by the amortization or annuity method need to be reviewed to determine which method generates the largest payout.

At the time of this writing (July 2014), the IRS’s current interest rate used in the amortization and annuity methods was, for both, 2.31%. This rate changes monthly, so a calculation performed six months later will likely produce a different result. If someone age 55 today had $100,000 in an IRA, amortization would generate the best result: a $4,701 annual payment that would need to be taken for five or six years, depending on when the individual turns 59½. (The annuitization method produced a $4,680 annual payment, while the life expectancy method produced a $3,378 annual payment.) (A 72(t) payment plan calculator can be found here at “Lord Abbett retirement calculators.”)  

Different ages and interest-rate changes could produce different results. [Please review all scenarios before proceeding to initiate a 72(t) pay down for one of your clients with the client’s tax advisor.]

If the individual above started his/her systematic withdrawals and wanted to change the payment for any reasons, including market declines that caused selling more and more shares to meet the required payment, he/she may do so once by switching to the life-expectancy method, which would then be used for the payment duration.

Multiple Accounts
The substantially equal payments come from one IRA or a combination of IRAs. If the 55-year-old individual wants to take an amount less than $4,497 per year based on having more than $100,000 in his/her IRA account, the account could be split into two or more IRAs. The nonpaying IRA(s) could then be utilized if additional distributions were needed at another point before age 59½ under the methods described above or some other purpose, including simply being left to accumulate. Splitting the IRAs, in order to have one IRA function as the distribution funding source, avoids tying up more IRA assets than necessary to achieve the desired result, although an IRA account holder will generally need to pay an additional annual account fee to have multiple IRA accounts.

Any trailing distributions from qualified plans that take place once the Section 72(t) distribution commences should be contributed to a nonpaying (or new) IRA to avoid triggering a modification (e.g., contribution or distribution in excess of the 72(t) calculated amount) of the payment plan and the imposition of the 10% penalty on the amounts already distributed. One should be similarly inclined to do the same should a client decide to make an additional IRA contribution. The basic idea is to make sure the IRA being used to produce the additional income is not modified.

Under the Roth IRA regulations, an amount being received under Section 72(t) can be converted to a Roth IRA without incurring a modification of the payments. Taxes based on the client’s tax rate at the time of conversion would be payable on the entire IRA account balance being converted, and distributions of already taxed money would continue.

Potential Pitfalls
Here’s one trap for the unwary, though. Let’s say our 55-year-old above turns 59½ in 2019 and takes $4,497 per year through 2019. The five-year rule is not satisfied until 2019 ends. This person could not take an additional payment amount from this IRA until 2020 without tax ramifications. For example, taking an additional $2,000 above the $4,497 after reaching age 59½, but before the end of 2019, would trigger the 10% penalty on all distributions made before age 59½. Prior to beginning payment know your end date.  Further, check each year in December confirming total annual distributions.

Constant-dollar systematic withdrawal plans operating in a down market can potentially deplete an account rapidly. So as to not add insult to injury, should an individual’s IRA run out of money before the prescribed time and/or age, the IRS does not consider the depletion of the account, while following the payment scheme initially created, a modification that would trigger the imposition of the 10% penalty on amounts already distributed.

Here’s the bottom line: Payments under Section 72(t) can be a very attractive supplemental or retirement income source; but be sure that the tax implications attached to distributions commencing, and perhaps stopping, as well as what can happen to the investment itself, are understood by all parties concerned, especially the taxpayer. 

 

Important Information:

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

Note: Minimum distributions must be taken from traditional IRAs by April 1 following the year that a person turns 70½. A minimum distribution must be taken from the IRA in each subsequent year. Failure to take the required minimum distribution will result in a 50% penalty on the amount that was not distributed. Mandatory distributions that represent deductible contributions and all earnings are taxed as ordinary income. Mandatory distributions based on nondeductible contributions are tax-free.

There may be administrative fees and other costs involved in a conversion to a Roth IRA.

A Simplified Employee Pension Plan, commonly known as a SEP-IRA, is a retirement plan specifically designed for self-employed people and small business owners.  When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP-IRA.

A SIMPLE IRA plan is an IRA-based plan that gives small business employers a simplified method to make contributions toward their employees’ retirement and their own retirement.  Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or non-elective contributions.  All contributions are made directly to an Individual Retirement Account (IRA) set up for each employee (a SIMPLE IRA).  SIMPLE IRA plans are maintained on a calendar-year basis.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

Please note: The examples in the preceding commentary are for illustrative purposes only and do not depict any particular client account or specific investment.

A Note about Risk: Investing involves risk, including the possible loss of principal.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

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