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George F. Bearup, J.D. Senior Legal Trust Advisor

4-Nov-20

Substantially Equal Periodic IRA Distributions

Take-Away: The Tax Code permits an IRA owner to take periodic distributions from their IRA prior to age 59 ½ without having to pay the 10% early distribution penalty. While this is an opportunity that many will explore if they are economically devastated due to the pandemic, entering into an substantially equal periodic payment plan carries multiple risks, and one should be pursued only with an abundance of caution.

Background: A statutory exception exists to the 10% early distribution penalty for a series of substantially equal periodic payments from an IRA. [IRC 71(t).] This exception permits an individual to access funds in their IRA account without incurring a 10% penalty if they are then under age 59 ½. However, there are many specific rules that must be followed to be able to access the IRA funds penalty-free. [IRC 72(t)(2)(A); Revenue Ruling 2002-62.] This distribution option can also be used with a Roth IRA, but usually that is only when Roth funds are needed and the Roth IRA has not been in existence for 5 years or the Roth’s earnings that are not yet qualified.

Goal: The primary goal of an IRC 72(t) distribution plan is to obtain the largest possible payment from the smallest amount of funds held in the IRA.

Targeted IRA: Unlike many of the Tax Code rules that apply to aggregated IRAs, the periodic payment plan can be applied only to one of many IRAs that is selected by the IRA owner. This permits some advance planning, since IRA funds can be rolled into, or out of, the targeted IRA to which the periodic distribution plan applies. This planning strategy is called splitting IRAs. This strategy permits the IRA owner to continue to have access to other IRA funds (albeit subject to the early distribution penalty) without messing up the substantially equal periodic payment plan (more on that concern below.)

Conditions: In order to qualify for a substantially equal periodic payment plan, the payments must (i) continue for at least 5 years or (ii) until the IRA owner is age 59 ½, whichever is longer.  Once the payments start, they cannot be modified during the payment term (with only a couple of limited exceptions noted below.) The five-year period ends on the fifth anniversary of the first distribution date; it does not end on the date of the fifth annual distribution. [Arnold v. Commissioner, 111 Tax Court 250, 1998.]

Payment Options: The IRA balance used to calculate the payment must be determined in a reasonable manner based on the facts and circumstances. The IRA owner has three options in which to take substantially equal periodic payments from his/her IRA. [Revenue Ruling 2002-62.]

  • RMD Method: Under the required minimum distribution (RMD) method, the amount is calculated in the same manner as other RMDs. It is not popular since it produces the lowest annual IRC 72(t) periodic payment.
  • Amortization Method: The amortization method permits, using either a calendar or fiscal year, a reasonable interest rate to determine the amount to be paid, which interest rate is not more than 120% of the federal mid-term rate for the month the plan starts, or the two prior months.
  • Annuity Method: The annuity factor method has the same flexibility that exists under the amortization method applies. Under either method, the IRA owner will usually receive consistently higher annual withdrawals, which is often most important for the IRA owner.
  • Switch: An IRA owner can switch from the amortization or annuity method of periodic payments to the RMD method, and that will not be treated as a modification. However, it is a one-time only, irrevocable, switch in methods.

Modification Recapture Penalty: This is where the substantially equal periodic payment plan creates the most risk for the IRA owner. If the IRC 72(t) plan is modified, the 10% early distribution penalty applies, not only to the distribution that effectively modified the payment stream, but also is applied retroactively to all distributions previously taken under the periodic payment plan. Restated, the penalty goes back several years to when the plan was first started and the first periodic payment was received.

  • Example: Kevin is furloughed as result of the pandemic and economic recession. Kevin is 45 years old. Kevin opts to take substantially equal periodic payments from his IRA. Those payments are $10,000 a year. Kevin must abide by that periodic payment plan until he is age 59 ½, or for the next 14 years. Later, when Kevin is age 57 and after he has religiously adhered to the periodic payment plan for the past 12 years, taking $10,000 a year, he takes a $50,000 distribution from his IRA (not $10,000.) Kevin’s 10% early distribution penalty is triggered and applied retroactively. The 10% penalty is applied not only on the $120,000 of previous withdrawals that Kevin has taken from his IRA ($10,000 a year for 12 years) he also pays the 10% penalty on the $50,000 distribution in the current year that modified his periodic payment plan. In short, Kevin will owe $17,000 in penalties, plus interest, all of which is due in the year of the periodic payment plan’s

Periodic Payment Modifications: It is pretty easy to trigger a modification of a periodic payment plan.

  • Missing a Payment: The easiest way is to simply miss taking the required amount, even if the differential amount is negligible.
  • Change in Account Balance: No matter what payment method is used, any change in the IRA account balance, other than regular gains and losses, will be considered a modification and the 10% penalty will be incurred. Accordingly, no new funds can be added to the targeted IRA either through rollovers or additional contributions. Similarly, if the IRA owner fails to take a distribution, e.g. he/she is reemployed and no longer needs the distribution, that too will be treated as a periodic payment plan modification.
  • RMD: If the RMD method of payment is selected, that allows the IRA owner to re-determine the IRA account balance with each year’s periodic payment. That change in account balances is not treated as a modification that triggers the 10% penalty. The RMD method requires the use of the prior year’s December 31 account balance, after the year in which the plan was adopted.
  • CARES Act: While the CARES Act waived RMD’s for 2020, that waiver does not apply to IRC 72(t) periodic payments, even though the RMD method of periodic payment is calculated as an RMD. However, the CARES Act’s coronavirus-related distribution is not considered a modification of a periodic payment plan.
  • Example: Jennifer, age 54, has been taking IRC 72(t) payments from her IRA for several years. Jennifer was recently diagnosed with COVID-19 and she needs to access her IRA in order to pay her medical bills.  Jennifer can take a coronavirus-related distribution from her IRA, a one- time change in her account balance, that will not be treated as a modification of her periodic payment plan associated with her IRA.
  • Death or Disability: The IRA owner’s death or disability will not be treated as a modification, so no retroactive 10% penalty will apply to the targeted IRA. It is the same result if the IRA’s balance drops to $0.00- that is not a modification either.
  • Divorce: The IRA owner’s transfer of a portion of the periodic payment IRA to a former spouse, with the resultant reduction in the IRA account’s balance, also does not result in a modification of the IRC 72(t) payment schedule. [Private Letter Ruling 201030038.]
  • Custodian Error: If the amount distributed to the IRA owner was the result of the IRA custodian’s mistake, that may not be treated by the IRS as a modification. [Private Letter Ruling 200503036.]

Conclusion: While it may be appealing to access an IRA penalty-free during these desperate economic times, an IRA owner needs to remember that IRC 72(t) is a long-term commitment that locks the owner into a payment plan that pretty much cannot be altered, not to mention that a simple mistake in distributions from the IRA will cause all of the prior distributions to be subject to the 10% penalty retroactively, plus interest. Entering into the substantially equal periodic payment plan will require both the IRA owner’s constant vigilance and discipline to closely follow the plan for its entire duration.