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12/26/03 - IRA Distributions Before Age 59 1/2

By: Investor Solutions, Inc.

So it's your plan to retire early at age 55. Does it worry you that you won't be able to tap into your IRA account without penalty until you reach age 59 ½? An individual who is under age 59 ½ and wants to withdrawal money from his retirement plan faces a special obstacle: the 10% penalty imposed by the IRS on retirement distributions received prior to age 59 ½. Well, great news! There's a highly useful and flexible exception to the penalty, known as "series of substantially equal periodic payments," which can be used to help you get money out of your IRA without having to pay the 10% penalty.

Currently, there are 12 exceptions to the 10% early withdrawal and most are triggered only in particular hardship situations (death, disability, medical expenses) or they are tied to a particular use of the money (home purchase, college tuition). This article is going to focus on a well-kept secret, an IRS approved exception called the "series of substantially equal periodic payments" (SOSEPP) sometimes referred as "Section 72t withdrawals". This exception allows an IRA owner to take equal distributions from their IRA prior to Age 59 ½ provided the following conditions are met:

a) Payments must continue until the individual reaches age 59 ½ or until five(5) years have elapsed, whichever occurs later.

b) Only the IRS approved methods for determining the size of the "equal payments" may be used.

c) Certain "Modifications" to the IRA are prohibited once SOSEPP has commenced. *

So how does this exception work? The premise starts that there is a sum of retirement funds that will gradually be depleted by withdrawal of a series of regular distributions over the life expectancy of the individual. However, payments are only required to be made for five (5) years, or until the participant reaches age 59 ½ , if later. To qualify as a SOSEPP distribution, the IRS has set forth three (3) methods for calculating the periodic payments:

• The Required Minimum Distribution Method
• The Fixed Amortization Method
• The Fixed Annuitization Method

Under the Required Minimum Distribution Method, the annual payment is recalculated each year by dividing the December 31st account balance (for previous year ending) by the number from the IRS life expectancy table for that year. If this method is chosen, it is not deemed to be a modification to the SOSEPP even though the amount of the payments will change from year to year.

The second approved calculation is the Fixed Amortization Method, here the annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years using the chosen life expectancy table and a "reasonable interest rate". As far as "reasonable interest rates" are concerned, the IRS has approved rates from as low as 5.6% to as high as 8.2%. This second method creates a predictable stream of payments that will remain equal in each subsequent year. No further calculations are required under this method.

The final method is the Fixed Annuitization Method, where the annual payment 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 taxpayer's age and continuing for the life of the taxpayer. The annuity factor can be derived by using the IRS approved mortality table or any "reasonable mortality table" and once again applying a reasonable interest rate. Also under this method, the payments will remain a fixed amount for subsequent years.

The minimum distribution method is the least used method, possibly because it requires a new calculation each year or perhaps due to the fact that it does not produce steady predictable income flows. Under minimum distribution, the amount of the payment from year to year will depend on investment results. While on the other hand if your looking for a fixed dollar amount, the amortization method is the most popular used method, and the annuity factor method tends to produce the largest payments out of the three choices. As far as modifications are concerned, once you start a SOSEPP you are not permitted to make certain modifications to the plan. This includes rolling over new funds to the IRA, taking additional distributions, early termination of the series of payments, taking an extra payment, changing distribution methods*, or changing from annual payment to monthly (even if the total payments add up to the correct amount all payments should be equal or otherwise exact to what was initially set up, the IRS has currently not ruled favorably or negatively that this switch would constitute a modification) Such modifications not only subject the current year's distribution to the 10% penalty, but also all distributions taken in previous years, this is not a good thing.

So, what's a smart planning tip to get exactly the payment you would like each month?

Let's look at an example; suppose Joyce, age 51, has one large IRA and she needs $1000 per month until age 59 ½. Tinkering with the three methods available for calculation they required an SOSEPP payment between $2500 to $3200 per month. Since Joyce only desires to receive $1000 per month, the large value of her IRA and methods allowed for calculation will not produce an amount as small as she wants. What should she do? Split the IRA into two, one of which is just the size to support a series of payments of the amount that Joyce desires. The IRS absolutely forbids the using of only part of an IRA to support a series, but the taxpayer can easily get the same result by dividing one IRA into two. This prohibition is simply a deterrent for the naïve, now you know enough to split your IRA, tell your friends.

* Effective in 2002, the IRS released a new Revenue Ruling 2002-62, which allows an individual that began distributions in a year using either the fixed amortization method or the fixed annuitization method to switch to the required minimum distribution method. This will not be treated as a modification, however; the required minimum distribution method must now be followed in subsequent years. This is a powerful revision to help

those with poor performance in their IRA accounts, mainly due to improper asset allocations and poor diversification strategies.

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