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3 new Private Letter Rulings have allowed taxpayers to recalculate their 72(t) payments annually. These IRA owners, who were taking substantially equal periodic payments under the annuitization or amortization method, were allowed to refigure the payout annually instead of staying with a flat annual payout. The rulings only apply to those taxpayers who got the letters, but they do indicate to us that the IRS might be flexible in going beyond the safe harbor SEPPs.
Start at the beginning: There is a 10% penalty for taking distributions from an IRA before age 59 ½. However, Code section 72(t) allows an exception for taking distributions as part of “a series of substantially equal periodic payments” (SEPPs).
Three years ago, the IRS defined 3 “safe harbor” methods for figuring SEPPs:
- the annuitization method,
- the amortization method, and
- the life expectancy (MRD) method
Under the annuitization and amortization methods, you figure out the dollar amount of the payment once, using the method, and withdraw that same dollar amount from the account every year. Under the life expectancy method, though, the payment fluctuates year to year. That’s because you recalculate: you divide the account balance every year by the remaining life expectancy. The IRS deemed life-expectancy payments “substantially equal” because you use the same method to figure the payments each year.
If you modify your SEPP stream before the later of 5 years or reaching 59 ½, you will have to pay the 10% penalty on all distributions before age 59 ½.
As it works out, the annuitization and amortization methods give a much higher payment (at least in the early years) than the life expectancy method. That made those methods the attractive choice for people trying to bridge the gap between early retirement and the beginning of Social Security benefits.
But people using the fixed annuitization and amortization methods ran into trouble during the bear markets of 2000-2002. As their account balances fell year after year from the stock market dive, the fixed dollar annuitization or amortization payments forced out a higher and higher percentage of the funds. Some people even depleted their retirement accounts. They could have shut off the income, but they would have incurred the 10% penalty for modifying the SEPP. They were caught between a rock and a hard place. (People using the MRD method did not suffer this dilemma. The MRD method recalculated each year, so they only withdrew a small percentage of the balance, whatever it was currently.)
The IRS offered some relief to stuck taxpayers by allowing a one-time switch from the annuitization or amortization method to the MRD method, saying they would not consider it a modification of the SEPP.
Making the switch was impractical for many people, because income would take a sharp dive. For example, suppose someone started an amortization payment at age 50 when the account balance was $200,000. The annual payment would be $10,559. Then suppose that after 3 years of payments and bear markets, the account fell to just $90,000. If the IRA owner switched to the life expectancy method, the payment would fall that year from $10,559 to just $2,866.
Taxpayers wanted to be able to use the higher payments offered by the annuitization or amortization methods, combined with the account protection offered by recalculation. Therefore some taxpayers asked the IRS if they can use the annuitization or amortization methods, but recalculate them annually. In a series of PLRs just published, the IRS allowed them to do that.
The IRS said that these taxpayers can recalculate their SEPP payment each year by applying the annuitization or amortization method to the current age of the owner, the current interest rate and the current account balance. That is, if they use the same method each year to recalculate their payments, it will be a SEPP exception to the 10% penalty.
Beware, though that a PLR only applies to the taxpayer who got the letter.
The IRS is not bound to allow others to use the recalculated methods. PLRs do give an indication of what the IRS is thinking, though. Also note that these PLRs dealt only with qualified accounts. They did not deal with nonqualified annuities.
The IRS has taken a pro-taxpayer stand with these PLRs, but until they provide us stronger guidance you should consider the risks before you adopt the recalculated annuitization or amortization method.
Margaret A. Kruse
Integrity Life Insurance Company
Last Updated: 8/30/2004 10:13:00 AM