Substantially equal payment exception.

• Author: Ellentuck, Albert B.

ONE OF THE MOST USEFUL EXCEPTIONS TO THE early distribution tax (particularly for IRA distributions before the taxpayer is age 59 1/2) is the exception for substantially equal payments. This exception may prove useful in situations such as:

* When an individual expects to be in a higher tax bracket when distributions would normally begin; or

* When an individual retires early (or becomes unemployed) before reaching age 59 1/2 and needs IRA distributions to meet living expenses.

For example, it may be years before the individual will be eligible for Social Security or other retirement benefits (if eligible at all), or such benefits may be sharply reduced if payments begin early.

To qualify under the substantially equal payments exception, the distribution must be part of a series of substantially equal periodic payments (SEPPs) made (at least annually) for the life (or life expectancy) of the individual or the joint lives (or joint life expectancies) of the individual and his or her designated beneficiary. However, distributions made under this exception do not need to actually continue for the life of the individual. Under Sec. 72(t)(4), payments may be altered (or stopped completely) after the later of:

* The date the individual turns age 59 1/2; or

* The close of the five-year period beginning with the date the initial payment was received.

If payments are altered before this time (except on account of death or disability), the tax is applied retroactively (recaptured) in the first year the modification is made (i.e., the tax is the amount that would have been imposed on the current and all previous distributions had this exception not applied). The tax is applied only to the payments received before the taxpayer turned 59 1/2, even if the recapture event occurs after this time (e.g., payments were changed before the end of the five-year period beginning with the date the initial payment was received but after the taxpayer turned 59 1/2). In addition, the taxpayer must pay interest on the tax, beginning with the tax year the penalty would have been payable and ending on the actual payment date (Sec. 72(t)(4)(A)(ii)(II)).

Example 1: T retires at age 50 and begins receiving $10,000 annual IRA distributions (calculated to be spread evenly over his life expectancy). Assuming T neither dies nor becomes disabled, the $10,000 distributions (no more and no less) need to continue at least until he is age 59 1/2 to avoid the early withdrawal penalty. After that he can modify or discontinue the distributions without incurring the penalty. Example 2: Assume instead that T is 57 when he retires and begins his IRA distributions. Here, to avoid the early distribution penalty, distributions must continue unmodified for at least five years after he takes the first one. Altering Distributions After Divorce

Although altering the payment before the end of the required payment period generally triggers the recapture tax, the IRS has allowed taxpayers who have divided IRAs due to divorce during this period to adjust their substantially equal payments without triggering the recapture tax. In Letter Ruling 9739044, the taxpayers divorced after substantially equal payments from three IRAs had begun. The IRAs were to be split equally between the spouses under the divorce...