Tax planning with substantially equal periodic payments.

• Author: Wasserstrum, David J.

Sec. 72(t)(1) generally imposes an additional 10% income tax on amounts received from a qualified retirement plan (as defined in Sec. 4974(c)), to the extent such amount is includible in gross income. For this purpose, the term "qualified retirement plan" generally includes a qualified plan described in Sec. 401 (a), a Sec. 403(b) tax-deferred annuity plan, and individual retirement accounts or annuities (IRAs) described in Sec. 408(a) and (b). There are a number of exceptions to the imposition of this additional 10% tax. Perhaps the most popular exception is for distributions made on or after the date on which the taxpayer attains age 59 1/2 (Sec. 72(t)(2)(A)(i)).

Another exception is allowed under Sec. 72(t)(2)(A)(iv), which provides that the additional 10% income tax does not apply to distributions that are part of a series of substantially equal periodic payments made (not less frequently than annually ) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his designated beneficiary. This exception does not apply to distributions from a qualified tax exempt trust (i.e., a Sec. 401(a) plan), unless the series of payments begins after the employee separates from service. This latter requirement is not applicable to IRAs.

Sec. 72(t)(4) provides that, if the series of substantially equal periodic payments is subsequently modified within five years of the date of the first payment (or prior to age 59 1/2), the exception to the 10% tax under Sec. 72(t)(2)(A)(iv) does not apply, and the taxpayer's tax for the year of modification is increased by an amount equal to the tax which, but for the exception under Sec. 72(t)(2)(A)(iv), would have been imposed, plus interest for the deferral period.

Notice 89-25, Q&A-12, provides three methods of distribution by which a series of payments may satisfy the substantially equal periodic payments exception. The distribution methods described in the notice are intended to serve as examples of substantially equal periodic payments and do not represent the only distribution methods that will satisfy the exception.

* Method 1: Payments will be treated as satisfying the substantially equal periodic payment requirement if the annual payment is determined using a method that would be acceptable for purposes of calculating the minimum distribution required under Sec. 401 (a) (9). For this purpose, the payment may be determined based on the employee's life expectancy or the joint life and last survivor life expectancy of the employee and beneficiary. To calculate the distribution, the account balance at the end of the prior...