72(q) & 72(t) Distributions
(t = qualified funds; q = non-qualified)
To discourage investors from accessing non-qualified annuity funds before retirement, distributions are generally subject to an IRS 10% early withdrawal penalty if a distribution is made from the annuity before age 59.5. However, there are several exceptions allowed through IRC Section 72(q)/72(t) where the penalty can be avoided. One such exception makes it possible to access retirement assets IRS penalty-free at any age, by receiving income as a series of substantially equal periodic payments. Substantially Equal Periodic Payments
This is a way of receiving an income stream based on the owner's life expectancy. A complete assessment of the client's financial situation should be performed and other sources of income should be exhausted before considering an IRC Section 72(q)/72(t) distribution. In addition, there are several other important considerations to review with your client when contemplating this option:
- If the amount or method of payment changes, the 10% penalty applies retroactively
- Generally, your client must continue to receive payments at least annually for 5 years or until age 59.5 (whichever is longer). Payments may be stopped after this time, if desired.
- Federal and State ordinary income taxes are still applicable
- There is a possibility your client could exhaust their retirement account early
- Special consideration should be given to an IRC Section 72(t)/72(q) distribution from a single premium deferred modified guaranteed annuity. Because interest is credited to the contract daily and compounded annually, withdrawing interest will reduce the amount of interest earned each year.
There are three acceptable methods of calculating 72(q)/72(t) distributions:
- Life Expectancy Method
- Calculated by dividing the annuity account balance by a life expectancy factor that is published in the IRS tables
- Payment amounts must be recalculated annually
- Since payments are recalculated based on life expectancy, the payment amount will vary from year to year. Generally, this method provides for smaller payments in the beginning, with payments increasing annually over time.
- Amortization Method
- Calculated by amortizing the annuity account balance over the life expectancy of an individual, or the joint life expectancy of an individual and designated beneficiary, by using IRS mortality table and reasonable interest rate.*
- Payments are NOT recalculated annually and remain constant over time
- Annuitization Method
- Calculated by dividing the annuiy account balance by an annuity factor that is published in the IRS mortality tables and a reasonable interest rate.*
- This method does NOT require annuitization of the contract
- Payments are not recalculated annually and remain constant over time
A tax advisor should carefully consider the initial funding amount, payment method (including interest rate assumption), payment frequency, and investment options. Investment performance should be monitored and periodically adjusted as necessary to ensure assets are sufficient to continue the specified IRS Section 72(q)/72(t) payment amount.
In addition, any 72(q)/72(t) distribution payment over the free withdrawal provisions of the specified contract will be subject to surrender charges and applicable market value adjustment.
*IRC Section 72(q)/72(t) Distribution Interest Rate
IRS general information letter (INFO 200-0226) states that the interest rate used for 72(q)/72(t) distribution calculations must be a "reasonable interest rate" equivalent to 120% of the Federal Mid-Term Rate. Your client should consult with his/her tax advisor to determine the assumed interest rate to use.
Last Updated: 9/23/2012 10:05:00 PM