Back to Early Distributions

Early Distributions

  • 3674. What penalties apply to early distributions from an IRA?

    • Except as noted below, amounts distributed from a traditional IRA or a Roth IRA to the individual for whom the plan is maintained before such individual reaches age 59½ are early (premature) distributions. To the extent such distributions are taxable, they are subject to an additional tax equal to 10 percent of the amount of the distribution that is includable in gross income for that particular tax year.1 The tax is increased to 25 percent in the case of distributions from SIMPLE IRAs (Q 3703) during the first two years of participation.2

      The 10 percent penalty tax does not apply to the following:

      (1) Distributions made to a beneficiary or the individual’s estate on or after the death of the individual.3

      Planning Point: If a surviving spouse is under age 59½ and elects to be treated as the owner of a decedent spouse’s IRA (generally, for required minimum distribution purposes), distributions may be subject to the early distribution penalty unless an exception applies. The early distribution penalty would not apply to distributions after the death of the original owner in the absence of the spouse making the election to be treated as owner.

      (2) Distributions attributable to the individual’s disability.4

      (3) Distributions made for medical care, but only to the extent allowable as a medical expense deduction for amounts paid during the taxable year for medical care (determined without regard to whether the individual itemizes).5 Thus, only amounts in excess of 10 percent of the individual’s adjusted gross income (“AGI”) escape the 10 percent penalty. (The threshold amount was 7.5 percent for tax years prior to 2013, and was again 7.5 percent for 2017-2018.)

      (4) Distributions made to unemployed individuals for the payment of health insurance premiums. The AGI floor, described above, does not have to be met if the individual has received unemployment compensation for at least twelve weeks and the withdrawal is made in either the year such unemployment compensation was received or the year immediately following the year in which the unemployment compensation was received. This exception also applies to self-employed individuals whose sole reason for not receiving unemployment compensation is that they were self-employed. The exception ceases to apply once the individual has been reemployed for a period of sixty days.6

      Planning Point: If an IRA owner pays health insurance premiums in a year of unemployment, and the owner expects to need an IRA distribution within the next few years at a time when the owner does not anticipate that any other exception will apply, the owner should consider taking an IRA distribution in the year of unemployment to avoid a future penalty tax on that amount. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

      (5) Distributions made to pay “qualified higher education expenses” during the taxable year for the taxpayer, the taxpayer’s spouse, or the child or grandchild of the taxpayer or the taxpayer’s spouse.7 “Qualified higher education expenses” means tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the student at any “eligible educational institution.” For tax years beginning after 2001, this includes expenses for special needs services in the case of a special needs beneficiary that are incurred in connection with such enrollment
      or attendance. Room and board (up to a certain amount) also is included if the student is enrolled at least half-time.8 “Qualified higher education expenses” must be incurred for the taxable year of the distribution.9 These expenses must be reduced by any scholarships received by the individual, any educational assistance provided to the individual, or any payment for such expenses (other than a gift, devise, bequest, or inheritance) that is excludable from gross income.10 An “eligible
      educational institution” is any college, university, vocational school, or other postsecondary
      educational institution described in Section 481 of the Higher Education Act of 1965.11 Thus, virtually all accredited public, nonprofit, and proprietary postsecondary institutions are considered eligible educational institutions.12 This exception to the 10 percent penalty is not available if the withdrawal qualifies for one of the other exceptions provided under IRC Section 72(t)(2) (other than the following exception for “qualified first-time homebuyers”).      13

      Planning Point: If an IRA owner has higher education expenses in a given year and he or she expects to need an IRA distribution within the next few years at a time when he or she does not anticipate that any other exception will apply, the IRA owner should consider taking an IRA distribution in the year of the higher education expenses to avoid a future penalty tax on that amount. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

      (6) Distributions that are “qualified first-time homebuyer distributions” (Q 3670). This exception to the 10 percent penalty is not available if the withdrawal qualifies for one of the other exceptions provided under IRC Section 72(t)(2).14

      (7) Distributions that 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 or her designated beneficiary (Q 3676).15

      (8) Distributions that are “qualified hurricane distributions” (these distributions may not exceed $100,000).16

      (9) Distributions that are “qualified reservist distributions.” Qualified reservist distributions are those made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to return the amount of any distributions to the retirement plan for two years following the end of active duty.17

      The penalty tax has been held not to apply to compulsory distributions where the IRS levied on a taxpayer’s IRA and where the federal government seized a taxpayer’s IRA as part of a plea agreement.18

      Where a taxpayer withdrew from his IRA to satisfy a court order to pay alimony and child support, the penalty tax did apply.19

      No early distribution occurs where accumulation units in an individual retirement annuity are surrendered to purchase a disability waiver of premium feature.20 Ineligibility to set up an individual retirement plan does not prevent imposition of this penalty.21 The fact that an IRA distribution was mandated by the insolvency of the financial institution issuing the IRA did not prevent the application of the 10 percent penalty tax when the funds were received and not rolled over.22

      The amount reportable as an early distribution from a time deposit (such as a certificate of deposit) that is subject to an early withdrawal penalty of the trustee is the net amount of the distribution after deduction of any early withdrawal penalty imposed by the trustee.23

      It appears that amounts includable in income as a result of a prohibited transaction, borrowing on an annuity contract, or using an account as security for a loan would be subject to the 10 percent penalty.24

      1. IRC Sec. 72(t).

      2. IRC Sec. 72(t)(6).

      3. IRC Sec. 72(t)(2)(A)(ii).

      4. IRC Sec. 72(t)(2)(A)(iii).

      5. IRC Sec. 72(t)(2)(B).

      6. IRC Sec. 72(t)(2)(D).

      7. IRC Sec. 72(t)(2)(E).

      8. IRC Secs. 72(t)(7), 529(e)(3).

      9. Lodder-Beckert v. Comm., TC Memo 2005-162 (2005).

      10. IRC Sec. 72(t)(7)(B).

      11. See IRC Sec. 529(e)(5).

      12. Notice 97-60, 1997-2 CB 310, at 14 (Sec. 3, A16).

      13. IRC Sec. 72(t)(2)(E).

      14. IRC Sec. 72(t)(2)(F).

      15. IRC Sec. 72(t)(2)(A)(iv).

      16. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

      17. IRC Sec. 72(t)(2)(G).

      18. Larotonda v. Comm., 89 TC 287 (1987), nonacq.; Murillo v. Comm., TC Memo 1998-13, aff’d. 166 F.3d 1201 (2nd Cir. 1998).

      19. Baas v. Comm., TC Memo 2002-130. See also Czepiel v. Comm., TC Memo 1999-289, aff’d. by order (1st Cir. 2000).

      20. See Let. Rul. 7851087.

      21. Orzechowski v. Comm., 69 TC 750 (1978), aff’d 79-1 USTC ¶7220 (2nd Cir. 1979).

      22. Aronson v. Comm., 98 TC 283 (1992).

      23. Let. Ruls. 8643070 and 8642061.

      24. IRS Pub. 590-A (2017).

  • 3675. What strategies should a taxpayer consider when determining the level of distributions from retirement accounts during retirement?

    • Depending on a taxpayer’s unique circumstances, there are many different approaches that an advisor may take to help determine an appropriate distribution level. Two traditional strategies that are commonly used are the “4 percent rule” (see below) and the RMD method, which uses the IRS’s required minimum distribution rules to make the determination.

      The RMD rules (Q 3679) require that taxpayers begin withdrawing funds from tax-deferred retirement accounts, such as IRAs and 401(k)s, when they reach age 70½. The minimum amounts that must be withdrawn are calculated based on the taxpayer’s life expectancy, determined using IRS actuarial data.1

      The IRS provides tables specifying the percentage of current account assets that must be withdrawn each year based on the life expectancy of the taxpayer in any given year after reaching age 70½ (tables are also available for taxpayers beginning withdrawals at younger ages). In the case of a married couple where one spouse is more than ten years younger than the other, the joint life expectancy of the couple is used in the calculation to provide a more realistic estimate of the combined life expectancy of the couple.2

      The RMD requirements are generally not meant to provide retirees with guidance on the optimal withdrawal rate, but are meant to ensure that the funds in these tax-deferred accounts are used for retirement income, rather than as estate planning vehicles. Because the requirements seek to ensure that the assets are spent during life, they are a viable alternative to the so-called “4 percent rule,” even though this was not the original IRS intent in formulating the rules.

      As the name suggests, under the 4 percent rule, the taxpayer withdraws 4 percent of the beginning balance of retirement savings each year during retirement. While the rule is very simple, it can have unintended consequences. For example, the rigid 4 percent-per-year requirement tends to encourage taxpayers to seek out dividend-heavy investments to supplement their otherwise fixed income, regardless of whether those investments are otherwise appropriate.

      Further, the 4 percent rule has taxpayers withdraw 4 percent even in years when their assets may have severely underperformed. The converse is also true, as the rule limits taxpayers to 4 percent withdrawals even if they could afford much more.

      Some advisors find that the RMD method should be considered as a potential alternative to the traditional 4 percent rule for determining retirement account withdrawal rates. Not only is the RMD approach almost as simple as the 4 percent rule—rather than withdrawing 4 percent each year, the taxpayer would consult the IRS tables to determine the applicable percentage—but it offers much more flexibility.

      The RMD rule may be, in many ways, much more realistic than the 4 percent rule because it bases withdrawals on the current value of the taxpayer’s retirement assets. While this requires determining the account values each year, it also allows taxpayers to modify their consumption levels based on actual account performance. Because the percentages are based on life expectancy and vary with age, it is still unlikely that the taxpayer will outlive his assets.

      1. IRC Secs. 408(a)(6), 408(b)(3), 401(a)(9).

      2. Treas. Reg. §1.401(a)(9)-9.

  • 3676. How are substantially equal periodic payments from an IRA calculated for purposes of IRC Section 72(t)?

    • The 10 percent early (premature) distribution tax (Q 3674) does not apply to distributions that 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 or her designated beneficiary.1

      The IRS has approved three methods, explained below, under which payments will be considered to be “substantially equal periodic payments.”2 Regardless of which method is used, the series of payments must continue for the longer of five years or until the individual reaches age 59½. Ordinarily, a “modification” (see Q 3677) that occurs before this duration requirement is satisfied will result in the penalty and interest being imposed on the entire series of payments, in the year the modification occurs.3 However, a participant can (see Q 3677) change methods one time if certain requirements are met.4 A change in the payment series as a result of disability or death also does not trigger the penalty.5

      The three approved methods are as follows:

      1.   The Required Minimum Distribution (“RMD”) method: requires use of a calculation that would be acceptable for purposes of calculating the required minimum distributions under IRC Section 401(a)(9). Consequently, annual payments are determined each year by dividing the account balance by the owner’s current life expectancy obtained from one of three IRS tables (see below). Under this method, the account balance, the life expectancy, and the resulting annual payments are redetermined each year and can cause a variation in the payment from year to year. Such annual fluctuations will not be considered modifications.6 Under this method, the same life expectancy table used for the first distribution year must be used for each following year.7 Although the Worker, Retiree and Employer Recovery Act of 2008 (“WRERA 2008”) waived RMDs for 2009, this did not apply for purposes of the substantially equal periodic payment exception to the early distribution penalty.8

      2.   The fixed amortization method: requires annual payments determined by amortizing the individual’s account balance in level amounts over a specified number of years determined using the chosen life expectancy and interest rate as explained below.9 The account balance, life expectancy, and resulting annual payment are determined once for the first distribution year, and the annual payment is the same amount in each year thereafter.10 The ability to recalculate the amount of the payment each year by using the taxpayer’s life expectancy with the amortization method was approved in a letter ruling.11

      3.   The fixed annuitization method requires annual payments determined by dividing the individual’s account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the individual’s age attained in the first distribution year and continuing for the life of the individual (or the joint lives of the individual and a beneficiary). The annuity factor is derived using the mortality table provided in a 2002 IRS guidance and an interest rate chosen as explained below. The account balance, annuity factor, interest rate, and resulting annual payment
      all are determined once for the first distribution year and the annual payment is the same amount each year thereafter.12 The ability to recalculate the amount of the payment each year by using the taxpayer’s life expectancy with the annuitization method was approved in a letter ruling.      13

      The three life expectancy tables that may be used to calculate substantially equal periodic payments are: the single life expectancy table, the joint and last survivor life expectancy table, and the uniform lifetime table.14 (Because the uniform lifetime table in the RMD regulations begins at age seventy, the IRS included an expanded version covering a broader range of ages.)15 All three tables are reproduced in Appendix F – 01.

      For the amortization method, an interest rate must be used that does not exceed 120 percent of the federal mid-term rate (determined in accordance with IRC Section 1274(d)) for either of the two months immediately preceding the month in which the distribution begins.16

      Planning Point: The RMD method is the simplest calculation, but will need to be recalculated every year. The amortization and annuitization calculations are more complex, but only need to be performed once.

      The IRS has stated that individual retirement plans do not have to be aggregated for purposes of calculating a series of substantially equal periodic payments.17 If a taxpayer owns more than one IRA, any combination of the IRAs may be taken into account in determining the distributions by aggregating the account balances of those IRAs. But a portion of one or more of the IRAs may not be excluded to limit the periodic payment to a predetermined amount.18

      Planning Point: The ability to split up or aggregate IRAs in advance of a payout makes the calculation extremely flexible. Furthermore, creating separate accounts is a good way to avoid tying up any more IRA funds than is absolutely necessary to support the needed payout.

      If an individual with more than one IRA chooses to base a series of substantially equal periodic payments on the total of all of his or her IRAs, the annual distribution may be received from any or all of the accounts.19

      Planning Point: It generally is useful to select the substantially equal periodic payment method that comes closest to withdrawing the amount that is desired. Under the amortization or annuitization  methods, higher interest rates result in higher payments; lower interest rates result in lower payments. In general, having a designated beneficiary can reduce the amount of the payments (calculations can be based on two lives rather than one); a younger beneficiary results in lower payments, an older beneficiary results in higher payments. Selecting IRA accounts with a lower aggregate account balance results in lower payments; selecting IRA accounts with a higher aggregate account balance results in higher payments.

      1. IRC Sec. 72(t)(2)(A)(iv).

      2. Rev. Rul. 2002-62, 2002-2 CB 710, modifying Notice 89-25, 1989-1 CB 662, A-12.

      3. IRC Sec. 72(t)(4).

      4. Rev. Rul. 2002-62, 2002-2 CB 710.

      5. IRC Sec. 72(t)(4).

      6. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(a).

      7. Rev. Rul. 2002-62, 2002-4 CB 710, Sec. 2.02(a).

      8. Notice 2009-82, 2009-2 CB 491.

      9. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(b).

      10. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(b).

      11. Let. Rul. 200432021.

      12. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(c).

      13. Let. Rul. 200432023.

      14. See Rev. Rul. 2002-62 and Treas. Reg. §1.401(a)(9)-9.

      15. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(a).

      16. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(c).

      17. See Let. Ruls. 200309028, 9050030.

      18. Let. Rul. 9705033.

      19. See Let. Rul. 9705033.

  • 3677. When is a series of substantially equal periodic payments from an IRA “modified” and what are the results?

    • Except in the event of death or disability, a change in payouts after the series has begun generally will constitute a “modification” and will trigger the early distribution penalties discussed in Q 3674.1

      A modification to the series of payments generally will occur if the taxpayer makes any of the following: (1) any addition to the account balance (other than gains or losses); (2) any nontaxable transfer of a portion of the account balance to another retirement plan; or (3) a rollover of the amount received, resulting in such amount not being taxable.2

      The IRS has determined that a change that does not alter the annual payout (such as a change from quarterly to monthly payments) is not a modification for this purpose.3 The receipt of a qualified hurricane distribution (Q 3668) also will not be treated as a change in a series of substantially equal periodic payments.4 However, once a change to the RMD method has been elected, no further changes may be made to the method of payment.

      The IRS has stated that an individual who begins distributions using either the amortization method or the annuitization method may, in any subsequent year, switch to the RMD method to determine the payment for the year of the switch and all subsequent years. Regardless of when the payments began, a taxpayer making such a change will not be treated as having made a “modification.”5

      Planning Point: The ability to switch to the RMD method makes the amortization and annuity methods more attractive, particularly for a participant who has a short term need for larger distributions
      which he or she expects will diminish in a few years. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC, New York, New York.

      A taxpayer who made the one-time RMD method change late in 2002 was permitted to roll over amounts in excess of the RMD amount back to the IRA in early 2003 even though the sixty day limit (Q 4003) had elapsed.6 The IRS determined that an inadvertent rollover of a small IRA balance into a large IRA from which a series of substantially equal periodic payments was in progress was not a modification.7

      The IRS has also ruled that a series of substantially equal periodic payments was not modified where, as a result of an error made by the entity distributing the funds, additional distributions were made by the entity from a second account maintained by the taxpayer before the funds from the first account were exhausted. This resulted in two additional, unrequested distributions. The taxpayer was able to provide proof that the error was made after the entity maintaining the account was acquired by another entity. She further certified that she had not requested the additional distributions and did not intend to modify the series of substantially equal periodic payments. As a result, the IRS found that the additional distributions were not a modification of the series of substantially equal periodic payments.8

      Planning Point: Qualified plans often make a trailing distribution subsequent to making a lump sum distribution to a former employee’s IRA. The IRS currently holds the position that if the participant has started a 72(t) payout from the receiving IRA, the trailing distribution will trigger a modification. Participants starting a 72(t) payout following a lump sum distribution should consider moving the funds to a different IRA prior to beginning the payout. Robert S. Keebler, CPA, MST, Virchow, Krause & Company, LLP, Green Bay, Wisconsin.

      The commencement of another series of substantially equal periodic payments (i.e., from a different IRA) does not constitute a modification of an existing payout, and the IRS has stated privately that nothing in the IRC or regulations prevents a subsequent payout series.9 One case determined that a distribution from an IRA that satisfied the early distribution penalty exception for qualified higher education expenses was not a modification of a series of substantially equal periodic payments from the same IRA.10

      1. IRC Sec. 72(t)(4).

      2. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(e).

      3. See Let. Rul. 8919052.

      4. Notice 2005-92, 2005-2 CB 1165, Sec. 4H.

      5. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.03(b).

      6. Let. Rul. 200419031.

      7. See Let. Rul. 200616046.

      8. Let. Rul. 201510060.

      9. See Let. Rul. 200033048.

      10. Benz v. Comm., 132 TC 330 (2009).

  • 3678. What are the results if an IRA account owner depletes the IRA account through properly pre-determined substantially equal periodic payments?

    • The penalty under IRC Section 72(t) will not be applied if, as a result of applying an acceptable method of determining substantially equal periodic payments, an individual depletes his or her account and is unable to complete the payouts for the required duration period under IRC Section 72(t)(4).1

      1. Rev. Rul. 2002-62, 2002-2 CB 710, Secs. 2.03(a) and 3.