Substantially equal periodic payments from an IRA.

• Author: Burilovich, Linda
• Position: Individual retirement accounts

EXECUTIVE SUMMARY

* Under the substantially equal periodic payment exception, the account owner must withdraw a substantially equal amount from an IRA annually for five years or until the taxpayer reaches age 59 1/2. The amount that must be withdrawn is based on the taxpayer's life expectancy.

* Three safe-harbor methods are available for calculating the annual withdrawal amount: (1) the required minimum distribution method, (2) the fixed amortization method, and (3)the fixed annuitization method. Each method produces a different annual withdrawal amount.

* The IRS has been willing to approve taxpayers' requests to use reasonable variations on the safe-harbor methods to calculate their annual withdrawal amounts.

* Modification or termination of the SEPP before the end of the required time period results in a retroactive application of the 10% penalty to all previous withdrawals and interest charges from the date each withdrawal was received until the modification or termination occurred.

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In the current economic climate, unexpected circumstances may cause many individuals to consider early withdrawal of IRA funds. Minimizing the tax consequences of these withdrawals means carefully considering opportunities to avoid the 10% penalty applicable to premature distributions.

While all distributions from a traditional IRA will be subject to income tax under the annuity rules in Sec. 72, an additional penalty is imposed on the taxable portion of distributions occurring before the owner reaches age 59 1/2. (1) Exceptions apply that allow the IRA owner to avoid this penalty if specific conditions are met. For example, withdrawals due to the owner's death or disability are not subject to the penalty. (2) Distributions for qualified medical expenses, (3) qualified education expenses, (4) first-time homebuyers, (5) and health insurance premiums paid by the unemployed, (6) as well as qualified hurricane distributions (7) and qualified reservist distributions for the military, (8) are all exempt from the penalty (subject to certain requirements). Distributions that are part of a qualified series of substantially equal periodic payments made annually to the IRA owner are also exempt from the penalty. (9)

Of all the techniques available to avoid the early distribution penalty, the substantially equal periodic payments (SEPP) alternative is the most universally available. It does not rely on preexisting conditions such as medical or educational expenses but is available to any IRA owner who is willing to calculate and sustain withdrawals according to the rules specified by the IRS. Thus, it provides an opportunity to fund early retirement or meet payments on long-term debt obligations without the imposition of the penalty. This can mean substantial savings on large IRA withdrawals.

This article examines the formulas provided by the IRS as safe-harbor methods for calculating the SEPP amount. Factors in the formula that are subject to discretion are highlighted, and the discussion focuses on how they may be used to adjust the payment to a preferred amount and still avoid the premature distribution penalty. Using these factors to establish the SEPP amount in response to the IRA owner's objectives requires making choices at the beginning of the payment series.

For example, a client wishing to meet short-term financial needs with IRA distributions may prefer to maximize the SEPP withdrawal over the shortest possible time period. This objective would be met by choosing among several approved formulas, interest rates, and life expectancies to calculate the maximum payment. However, if the objective is to fund a long-term commitment such as early retirement, the client may prefer to limit the payment amount in order to extend the series over a lengthy period. In this case the same factors could be used to maximize the distribution period. Strategic choices made in establishing the SEPP will permit the IRA owner to exercise some control over the amount to be received consistently over the payout period.

SEPP Calculation

Under the SEPP exception, the account owner must withdraw substantially equal amounts from the IRA annually. The annual payment is calculated based on a period equal to the owner's life or life expectancy, Or the joint lives or joint life expectancy of the owner and his or her designated beneficiary. (10) The payments must continue for a minimum period that extends to the later of five years or the owner's reaching age 59 1/2. (11) For example, payments beginning at age 58 must continue to age 63, while payments beginning at age 50 must continue to age 59 1/2. Modifications to the payment amount before this time period expires will trigger a retroactive application of the 10% penalty. (12) The payment can be altered without penalty due to death or disability.

The amount to be withdrawn annually is calculated according to one of three methods provided by the IRS in Rev. Rul. 2002-62. (13) The method chosen to calculate the first year's distribution must be used in subsequent years. The three methods approved by the IRS include (1) the required minimum distribution method, (2) the fixed amortization method, and (3) the fixed annuitization method. There are no restrictions on the IRA owner's choice of methods. The optimal choice will depend on the owner's liquidity needs, life expectancy, applicable interest rates, and expected tax rates during the payout period. Once selected, the method must be applied consistently. Modification or termination of the payment amount will generally have negative consequences.

The factors that give the IRA owner discretion over the amount of annual distribution in the SEPP include choice of method, life expectancy table, interest rate, and account balance. Within allowable limits, these factors will collectively determine the payment's amount.

The Methods

The three methods provided by the IRS are generally interpreted as safe harbors for the payment calculation. Numerous letter rulings suggest that variations on these methods will be tolerated as long as they are consistent with the requirements of Sec. 72(0(4). As the following discussion indicates, the three methods can yield different payment amounts, so the choice should be made carefully. An example of the payment amounts calculated under each of the three methods and the factors influencing the computation are included following this discussion.

Required Minimum Distribution Method

Under the required minimum distribution method, the annual payment may vary from year to year. The payment amount for any tax year is determined by dividing the account balance's value for that year by the owner's current life expectancy obtained from one of three IRS tables. (14) A separate calculation is required for each...