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Substantially Equal Payments
The Internal Revenue Service levies an extra 10% tax on distributions from qualified plans and IRAs where the recipient is under age 59½. This penalty may be avoided by implementing a series of Substantially Equal Payments, an exception allowed under Section 72(t). Following is an explanation of how this exception is implemented:
Section 72(t)(1) of the Internal Revenue Code provides that if an employee or IRA owner receives any amount from the owner/employee plan prior to age 59½ the income tax is increased by 10% unless one of the exceptions in 72(t)(2) applies. For the purpose of this discussion this exception refers to a series of Substantially Equal Payments made for the life of the employee/owner or joint owner or employee/owner and beneficiary.
This means that a plan participant or IRA owner can take a distribution no less frequently than annually, based on individual or joint life expectancy, and avoid the additional 10% penalty on distributions taken prior to age 59½. Certain rules must be followed for compliance with this provision. They include the particular calculation method, life expectancy options, account balance determination, interest rate assumptions, age of owner, term of continuous distributions, and changes to any of these factors.
This exception to the 10% extra tax is especially valuable for those under age 59½ who have left their employer, often as a result of job loss, and have not been able to find other employment or need to supplement their income from their IRA account.
It works like this:
These distributions may begin at any age and must continue for at least five years and through age 59½. For example, distributions starting at age 53 must continue for seven or eight years including the year age 59½ is reached. Distributions starting at age 57 must be continued for five years. Once the minimum years of distribution have been met, they may be discontinued. If distributions are not continued for the minimum number of years, once started, the 10% additional tax, plus interest, will be applied to all distributions previously made under this provision.
The amount of annual distribution is determined by one of three methods taking into account the recipient's age, life expectancy, interest rate assumptions and IRA account balance. Each of the methods provides for different annual distribution amounts so there can be quite a difference between the minimum and maximum amounts allowed.
The distribution calculation may be based on a specific IRA or all IRAs of the individual.
Life Expectancy Tables that can be used are the IRS Single Life Expectancy table, the Joint & Survivor table, and the Uniform Lifetime table. These tables can be found at www.irs.gov, Publication 590 Individual Retirement Arrangements, Appendix C.
The three methods are:
Required Minimum Distribution, where the annual distribution is determined by dividing the account balance by a number from one of the three life expectancy tables. This usually results in the lowest annual distribution amount of the three methods. Each year a new table number and account balance are used for the calculation, giving a different distribution amount each year.
Fixed Amortization, where the annual distribution is determined by amortizing the account balance in level amounts over a specific number of years using one of the life expectancy table numbers. This involves using an IRS-approved interest rate assumption. This method results in the same distribution amount every year.
Fixed Annuitization, where the annual distribution is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the individual's age and continuing for the life of the individual or the joint lives of the individual and beneficiary. This involves using an IRS mortality table and an IRS-approved interest rate assumption. This method results in the same distribution amount every year.
The Interest Rate allowed for the Fixed Annutization and Fixed Amortization calculations is a published federal funds rate. There is some latitude in what rate to use, but the published interest rate is a maximum rate. It is often to the individual's advantage to use the highest interest rate allowable for this calculation because it provides the highest annual distribution.
Account Balance must be determined in a "reasonable manner based on the facts and circumstances." It might be the balance on December 31 of the previous year, or it might be a month-end balance of the IRA prior to the distribution calculation. The Required Minimum Distribution method requires a new calculation each year, so the previous year-end account balance might be most convenient. The other two methods do not require recalculation annually so the decision on account balance is made only once.
This example should help to understand the concept:
Dick was born on 4/15/48, age 55 in 2003. His wife Jane was born on 7/04/53, age 50 in 2003. He has an IRA with a value of $600,000 when he decides to begin distributions in November 2003. Here are the distribution amounts allowable under the three methods using the different life expectancy tables and the maximum interest rate allowed at this time, 4.4%:
| |
Required Minimum Distribution |
Amortized |
Annuitized |
| Single Life Expectancy |
$20,270 |
$36,644 |
$36,377 |
| Joint & Surv. Life Expect. |
$15,666 |
$32,682 |
$36,377 |
| Uniform Table |
$14,423 |
$31,683 |
$36,377 |
Dick may choose any of these options depending on his financial needs. If none of these amounts work for his situation, Dick may split his IRA into two IRAs and use one of them for this distribution. Or he may combine his other IRAs, if any, to give him a greater IRA account balance for his beginning calculation.
The distributions may be taken any time during the year, i.e. monthly, quarterly, or a one-time payment. It can be done on the first day of the year or the last. There can be federal withholding or no withholding, depending on the personal income tax situation.
Once started, Dick must continue to make these taxable distributions through the year in which he reaches age 59½, in this case 2007, by which time he will have met the five year minimum. If Dick had been born on 8/15/48 he would need to continue his distributions another year, 2008, because he will have reached age 59½ on 2/15/08.
Dick could make one change to the distribution method. A change from Fixed Amortization or Fixed Annuitization to the Required Minimum Distribution method is allowed. Once changed, the new method must be followed in all subsequent years.
The amount of the annual distribution for Fixed Amortization and Fixed Annuitization could be less than that shown above because a lower interest rate could be used. The amounts in the example above were calculated using the highest rate allowable at the time. Interest rates change monthly.
This provision (referred to as 72t) is essentially the same concept as receiving an employer's pension in monthly installments over his/her lifetime. Regardless of the age at which payments begin there would be no additional 10% penalty because the payments will be made over the lifetime of the individual.
The advantages of opting for the lump sum rollover from the qualified plan and beginning the Substantially Equal Payments are:
1. You, the account holder, determine if and when the payment distributions are to begin and end.
2. Once monthly annuity payments begin from a qualified plan no changes and no further access to that money are allowed. If you have elected a single life payout, when you die the payments stop, and if you have elected a joint and survivor payout for you and your spouse and your spouse dies, no new spouse or other beneficiary can be added later.
3. With an IRA account the money is always yours to manage, to invest or to spend as you wish.
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