Investor Education for Main Street America

Transfer of Partial IRA Account Balance Subjects Periodic Payments to 10% Penalty

Sep 2nd, 2009 | By | Category: 3rd Quarter (Age 40-60)

retirement-eggs_200IRA accounts are designed for retirement. If a person decides they want to access their account prior to age 59 1/2, they will incur a Federal Income Tax penalty for early withdrawal of 10% of the amount withdrawn. In addition, the amount withdrawn is deemed ordinary income and taxed as such. If that weren’t bad enough of a deterrent from early withdrawals, some states also have an early withdrawal penalty, for example in California it is 2.5%. So, if a person taking an early withdrawal is in the 25% income tax bracket, they would pay 25% income tax, plus 10% Federal penalty, plus 2.5% California penalty for a total tax of 37.5%.

This is intended to discourage people from invading retirement plans early. And, it generally works.

However, there are occasional cases in which a person simply must begin taking funds from their IRA. There is a way to avoid these penalties. It is known as the SEPP or “Substantially Equal Periodic Payments” plan also identified by the tax code as 72(t). These payments must continue until the person is age 59 1/2 or 5 years, whichever is later. If these payments are modified, all of the prior payments become subject to the penalties. You must be very careful about violating the rules if you embark on this plan.

Here is the story about someone who innocently got stung by “modifying” her payments.

In a recent IRS Private Letter Ruling the rigidity of the rules under IRC § 72(t) by which substantially equal periodic payments are exempt from the 10% early withdrawal tax is illustrated. An individual’s non-taxable transfer of a portion of her individual retirement account to another IRA constituted a prohibited “modification” of the payments, which the IRS ruled could not be corrected by reversing the transfer. The error resulted in the distributions she had taken over the prior seven years all being subject to the 10% early withdrawal tax and interest.1

Transfer of Only a Portion of the IRA Caused a Modification

In 2008, an individual taxpayer submitted a request to the IRS for a private letter ruling (PLR) after learning that her non-taxable transfer earlier that year of a part of her IRA resulted in a prohibited “modification” of the “substantially equal periodic payments” plan she had been taking from that IRA since 2002. The taxpayer had completed the transfer on the advice of a financial advisor who suggested she invest a portion of the IRA in certificates of deposit, which were not available at the current financial institution, but which were available for IRAs at another institution. After opening another IRA at the other institution, the taxpayer transferred a part of her original IRA. Later the same year, the taxpayer consulted with representatives of a third financial institution about the possible transfer of the remaining IRA assets and was informed that the prior transfer constituted a “modification” of her series of substantially equal periodic payments. In later speaking with her financial advisor she was told that the transfer would cause the imposition of the 10% early withdrawal tax, plus interest, on all amounts that had been withdrawn from the IRA since 2002.

Early Distribution Penalty Applies Retroactively

The taxpayer was age 56, and had begun taking substantially equal periodic payments from the IRA six years earlier at age 50, in 2002. IRC 72(t)(1) imposes a 10% tax on early distributions from qualified plans and IRAs. However, the tax is not imposed if the distributions are part of a series of “substantially equal periodic payments” that are made at least annually over the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and beneficiary. But, if the payments are modified (other than by reason of death or disability) before the individual reaches age 59-1/2, or after the individual reaches age 59-1/2 but before the close of the 5-year period beginning with the first payment, then the taxpayer is obligated to pay the 10% early withdrawal tax that would have been imposed on the earlier payments, plus interest.

“Substantially equal periodic payments” are calculated by using the account balance as of the first valuation date selected. Therefore, as the IRS explained in the letter ruling, a modification occurs if there is any (1) addition to the account balance other than gains or losses, (2) nontaxable transfer of a portion of the account balance to another retirement plan or IRA, or (3) rollover of the amount received so that it results in the distribution not being taxable.

Error Cannot Be Corrected by Reversing the Transfer

As a result, despite the fact that the transfer was made on the basis of erroneous advice from her financial advisor, and the taxpayer had proposed to correct the error by transferring the amount back to the original IRA, the IRS ruled that a “modification” had occurred and could not be corrected by undoing the transfer. Since the modification occurred in 2008, before the taxpayer reached age 59-1/2, she was obligated for that year to pay an additional 10 percent early distribution tax on the distributions she had taken from the IRA since 2002, plus interest.

It seems sort of unfair to the taxpayer since it was the result of incorrect professional advice and since she offered to restore the funds to their original position. This does underscore the importance of good advice before taking action in the more esoteric areas of practice. The rules really are quite clear, but not too many people take action under the SEPP provisions of 72(t) and as a consequence even many advisors are not clear on the rules.
1.PLR 200925044 (March 23, 2009)

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