One way to beat the 10% penalty tax on retirement plan distributions prior to age 59½ is by using a loophole in the tax code under Section 72 that allows for Substantially Equal Periodic Payments, but there's a hidden risk.
Once funds are inside the shelter of an Individual Retirement Arrangement (IRA), they are typically locked away until the account or annuity owner has reached age 59½. In order to access funds prior to that age may result in an additional 10% penalty tax (or, a penalty of 25% if the IRA was part of a SIMPLE IRA plan and still within the first two years of funding).
Internal Revenue Code Section 72(t) provides both the problem and the solution.
Section 72(t) provides that amounts distributed from a traditional IRA or a Roth IRA before an individual reaches age 59½ are classified as premature distributions. To the extent such distributions are taxable as income, they are also subject to an additional tax equal to 10% of the amount of the distribution.
The 10% penalty tax does not apply to distributions which are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the individual or the joint lives or joint life expectancy of the individual and his designated beneficiary. The IRS codes that deal with this exception are 72(t)(2)(A)(iv) and 72(t)(4)(A).
IRS Notice 89-25 describes (and Revenue Ruling 2002-62 continues the) three basic methods in which payments will be considered to be substantially equal periodic payments:
- The life expectancy method - calculated under the minimum distribution rules;
- The amortization method - amortize account balance using life expectancies and a reasonable interest rate;
- And the annuitization method - account balance divided by an annuity factor using both a reasonable mortality table and interest rate.
There are some serious investment risks when taking distributions which are part of a series of substantially equal periodic payments, if you use the wrong method, especially if you use the wrong investments.
The Hidden Risk
The recent bear market has taught an expensive lesson to investors who listened to the wrong financial advisors, who recommended the wrong products, and now their clients are facing a choice between a massive tax penalty, or continuing the negative reverse dollar cost averaging risk. We specialize in helping our clients avoid this hidden risk to a series of Substantially Equal Periodic Payments.
Do NOT accept the results of any free web calculator - verify their results to see if they match the results that the IRS produced and used in both IRS Notice 89-25 and Rev. Rul. 2002-62.
From 89-25: Male Age 50, 8% Interest & UP1984 Mortality.
- Life Expectancy: 33.1 years
- Amortized Payment: $8,679
- Annuity Payment: $9,002
From 2002-62 FAQ: Male Age 50, 4.5% Interest, $400,000 IRA
- Life Expectancy: 34.2 years
- Minimum Distribution: $11,695.91
- Amortized Payment: $23,134.27
- Annuity Payment: $22906.68