Over the years, we have written numerous articles on taking money from a qualified account prior to age 59-1/2 without a 10% penalty by using the technique of “a series of substantially equal periodic payments based upon life expectancy” (sometimes referred to as a “section 72(t) election”). Most of our readers are familiar with the three methods for calculating this amount set out by the IRS in Notice 89-25; they are:
- Determining the annual payout in the same manner as Required Minimum Distributions are calculated under Code section 401(a)(9),
- Amortizing the taxpayer’s account balance over life expectancy using a “reasonable” rate of interest, and
- Determining the annual payout by dividing the account balance by an “annuity factor.”
Readers not familiar with how the three Methods work should review some of our past articles prior to continuing with this article, as the following analysis assumes a basic understanding of the three methods.
Amounts determined using the three methods vary significantly from method to method. Method 1 is the simplest to understand and calculate, but it produces a much smaller payout than Methods 2 or 3. Ordinarily, the taxpayer desires as large a payout as possible, and in those cases Method 2 might be employed using as high an interest rate as the taxpayer and/or her advisor think they can get away with.
Method 2 generally produces a much higher payout, but was thought to be somewhat more inflexible than Method 1. Method 1 automatically has a degree of flexibility built in as each years payout is based upon the prior December 31 account balance; whereas, it was previously assumed that under Method 2, one calculation would be made at the beginning and that particular payout would continue for the length of the arrangement.
Using Method 2 could lead to payouts that are “too low” or “too high” where the account is invested in assets that can vary in value, such as individual securities, mutual funds, or variable annuities. For instance, suppose a section 72(t) election using Method 2 was made on January 1, 1998 for an IRA containing tech stocks. If the IRA doubles or triples in value over the period 1998-1999, then the payout based upon the 12/31/1997 balance is “too low.” On the other hand, if a 72(t) Method 2 election is made on January 1, 2000 for an IRA containing tech stocks that drop 50% in value over the period 2000-2001, then the payout is much “too high” using the 12/31/1999 balance.
In PLR 200105066, the IRS approved a way of calculating payouts under Method 2 that solves the problem of “too low” payouts in a rising market or payouts that are “too high” in a falling market. In this ruling, the IRS allowed the taxpayer to recalculate the annual payout each year using the prior year’s account balance. The prior year account balance would then be amortized over the remaining life expectancy using an interest rate equal to 120% of the current annual federal mid-term rate.
Using this strategy allows taxpayers with IRAs performing well to take larger payouts, while at the same time somewhat ameliorating forced liquidations into the teeth of a falling market, making it a welcome addition to the retirement planner’s arsenal of techniques.
Printed with the permission of Advanced Underwriting Consultants
Last Updated: 12/15/2002 11:47:00 AM