Retirement plans, IRAs, and annuities: avoiding the early distribution penalty.

• Author: Blankenship, Vorris J.
• Position: Individual retirement arrangements

The tax law imposes a 10% penalty on early distributions from retirement plans, individual retirement arrangements (IRAs), and annuities. Congress designed the penalty as a disincentive for early retirement and pre-retirement withdrawals. There are, however, numerous exceptions to the penalty, some age related and some not.

The penalty applies to distributions from qualified plans, tax-sheltered annuities (TSAs), eligible state or local government plans, IRAs, Roth IRAs, designated Roth accounts, nonqualified plans funded by trusts or annuities, and personally purchased annuities. (1) The penalty does not apply to distributions from eligible tax-exempt organization plans or nonqualified plans not funded by a trust or annuity. (2) Note that the term "taxpayer" as used in this article means any participant in an employer retirement plan (other than a beneficiary) or the owner of an IRA, Roth IRA, or annuity.

The early distribution penalty applies only to amounts that are includible in gross income. Thus, for example, it does not apply to the nontaxable portion of any distribution, nor does it apply to the portion of a distribution rolled over tax free from one plan or IRA to another plan or IRA or from one Roth IRA to another Roth IRA. (3) Furthermore, the penalty does not apply to qualified rollover contributions from a plan or arrangement to a Roth IRA or designated Roth account, even if the rollover is taxable. (4)

Congress has provided many other exceptions to the penalty, exceptions that may vary somewhat with the type of plan or entity making a distribution. This article first addresses those exceptions that are common to all plans and annuities and then discusses exceptions peculiar to specific types of plans or annuities. (Note that the IRS has not issued any final or proposed regulations dealing with the penalty and its exceptions, and the IRS abandoned a previous regulation project. (5))

Common Exceptions

The Age and Death Exceptions

Under the most significant generally applicable exception, the 10% penalty tax will not apply to any distributions on or after the date the taxpayer reaches age 59 1/2. It does not matter whether the taxpayer is then retired. (6) The penalty tax also does not apply to distributions to beneficiaries or to a taxpayer's estate after the death of the taxpayer. (7)

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The Disability Exception

The penalty does not apply to distributions to a taxpayer after he or she is disabled. (8) However, the disability of a spouse will not qualify a taxpayer for the exception, even in a community property state. (9) A taxpayer is disabled if he or she cannot do substantial work because of a physical or mental medical condition that will last for a long and indefinite period or from which the taxpayer will probably die. (10)

For this purpose, a taxpayer can do substantial work if the taxpayer is capable of working at his or her pre-disability or pre-retirement occupation, or a comparable occupation, with appropriate remediable treatment. Determination of the taxpayer's capability must take into account the taxpayer's education, training, and work experience but most importantly the nature and severity of the impairment. Thus, the regulations provide that a taxpayer "ordinarily" cannot perform substantial work if the taxpayer suffers from one of the following specific impairments:

1. Loss of use of two limbs or physical loss or atrophy of a limb due to certain progressive diseases.

2. Heart, lung, or blood disease causing breathlessness, pain, or fatigue on slight exertion.

3. Inoperable and progressive cancer or other terminal illness.

4. Severe loss of judgment, intellect, orientation, or memory due to brain damage or abnormality.

5. Mental disease requiring continued institutionalization or constant supervision.

6. Severe loss or diminution of vision, permanent and total loss of speech, or total uncorrectable deafness. (11) The courts tend to apply these regulatory standards narrowly. For example, the Tax Court has held that a taxpayer suffering from clinical depression did not qualify for the disability exception because he continued to trade stocks for himself and others. The court said the taxpayer was engaged in gainful activity because he intended to make a profit from his trading, even though his efforts yielded an overall loss. (The court did not consider the possibility that the taxpayer's condition may have diminished his ability to make a profit.) The court also found that the taxpayer's periodic consultation with psychiatrists did not rise to the level of institutionalization or constant supervision (item 5 above). (12)

   In another case, the Tax Court held that a taxpayer did not qualify for the disability exception because he did not show that his clinical depression was irremediable. The court stated that an impairment is remediable if reasonable treatment would allow gainful activity. In this case, the taxpayer actually continued to engage in gainful activity. (13) By contrast, a taxpayer did qualify for the disability exception after contracting AIDS and then suffering a nervous breakdown, (14) as did a taxpayer suffering from multiple sclerosis. (15)

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   Unfortunately, the courts frequently find that taxpayers have offered inadequate evidence of disability. For example, the receipt of private disability insurance payments and the taxpayer's uncorroborated testimony were insufficient to support the disability exception. (16) The Tax Court also denied the exception to a Christian Scientist whose religious beliefs prevented him from obtaining and offering a medical diagnosis of his condition. (17) Similarly, the court held that evidence of disability was insufficient even though the taxpayer (I) had lost custody of a child he was unable to nurture and (2) actually qualified for Social Security disability in a subsequent tax year. (18)

   The Substantially Equal Payment Exception

   The 10% penalty tax will generally not apply to a series of substantially equal periodic payments received annually or more frequently. (19) The periodic payments must start after retirement for qualified plans, TSAs, and eligible state or local plans. However, they may start either before or after retirement for IRAs, Roth IRAs, some funded nonqualified plans, and personally purchased annuities. (20)

   A taxpayer or beneficiary must receive the substantially equal payments over the taxpayer's lifetime, the joint lifetimes of the taxpayer and beneficiary, a period equal to the taxpayer's life expectancy, or a period equal to the joint and survivor life expectancy of the taxpayer and beneficiary. (21)

   Of course, annuity payments of equal amount over the specified periods will generally qualify as substantially equal. (22) For nonannuity payments, a taxpayer may choose any one of the following three methods to compute the amount of the payments: (23)

1. Fixed amortization method: Under this method, the taxpayer determines the annual payment by amortizing the initial account balance in equal amounts over the taxpayer's life expectancy (or the joint life expectancies of the taxpayer and beneficiary).

2. Fixed annuitization method: The taxpayer determines equal annual payments by dividing the initial account balance by an annuity factor. The annuity factor is the present value of an annuity of $1 per year for the life expectancy of the taxpayer (or the joint life expectancies of the taxpayer and beneficiary).

3. Required minimum distribution method: The taxpayer redetermines the annual payment for each distribution year by dividing that year's account balance by the taxpayer's life expectancy for the distribution year (or the joint life expectancies of the taxpayer and beneficiary). A taxpayer may permanently switch to this method from methods 1 and 2 for any year after commencement of payments. (24)

   Some deviations from the safe-harbor methods may be possible. For example, the IRS has allowed taxpayers who adopt methods 1 and 2 above to alter those methods by recalculating distributions each year using current account balances, life expectancies, and interest rates. (25) However, a taxpayer generally may not change to or from any such altered method after initial adoption of a method. (26)

   Furthermore, the IRS is unyielding in requiring taxpayers to adopt methods using life expectancies derived from the minimum distribution regulations and interest rates no greater than 120% of the federal mid-term rate. (27) Significantly, the Tax Court, in holding that a taxpayer's payments were not substantially equal lifetime payments, noted that the payments were greatly in excess of IRS safe-harbor amounts. (28)

   A taxpayer may take a lump-sum distribution from a plan or an IRA (or transfer the amount tax free to another plan or IRA) before commencing substantially equal payments from the remaining account balance. In the case of a qualified plan, TSA, or eligible state or local plan, the distribution or transfer need only be in connection with the commencement of substantially equal payments. (29) Nevertheless, if not rolled over, the lump-sum payment itself will generally be a taxable distribution and will be subject to the penalty unless an exception applies.

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   A taxpayer with several IRAs may compute substantially equal payments for two or more of them in the aggregate and may make the aggregate payments from any one or more of the covered IRAs. (30) A taxpayer may adopt at various times separate streams of substantially equal payments from different IRAs, using different safe-harbor methods of computation. (31)

   The IRS may also provide relief for payment methods that it ultimately determines do not qualify as substantially equal lifetime payments. In one private letter ruling, (32) the IRS allowed a taxpayer to restore without penalty certain excess distributions resulting from a series of payments that the IRS ultimately ruled did not qualify. The IRS...