Early Retirees Can Enjoy COLAs

BY MICHAEL LYNCH

In the past, if a taxpayer took a distribution from a traditional IRA account before he or she reached age 59 1/2, the withdrawal was generally subject to a 10% penalty. Under IRC section 72(t)(2)(A)(iv), however, IRA account owners who retire early can avoid this penalty by electing to receive their distributions in a series of equal periodic payments.

To take advantage of this provision, taxpayers must determine an annual payment amount at the time of retirement. When choosing an annual payment, taxpayers should take into account their current IRA balance, the projected future earnings the account will generate and their life expectancy.

In PLR 199943050, a 50-year-old taxpayer took early retirement, rolled over his corporate pension into an IRA and began taking equal periodic payments. After a few years, the IRA doubled in size because the stock market outperformed his prior expectations. The taxpayer asked the IRS if it was possible to modify his payment plan by adding an annual 4% cost-of-living adjustment (COLA) and by including a one-time “catch-up” amount. The IRS denied the request. It held the taxpayer could not modify the annual payment without triggering the 10% penalty for premature distributions.

Observation. There are ways early retirees can make their IRA payments keep pace with the market and not incur the 10% penalty. In 1995 the IRS privately ruled that IRA owners under age 591/2 could withdraw funds from the account with a built-in 3% annual cost-of-living adjustment as long as they had specified the COLA amount up front (PLR 199536031).

In addition, three methods are available for determining substantially equal payments. CPAs should know that one of these methods, the term-certain method, allows taxpayers to receive higher payments each year if they expect substantial future earnings from their IRA investments.

Under this method, the taxpayer’s IRA account balance at the time of retirement is divided by his or her remaining life expectancy. For example, assume at retirement the taxpayer has $600,000 in his or her IRA and a life expectancy of 30 years. The first-year distribution would be $20,000. If the stock market performed well, and the account balance grew to $660,000 the following year, the second-year distribution would be $22,759 [$660,000 (30–1)]. If the account balance for year three grew to $740,000, the distribution that year would be $26,429 [$740,000 (30–2)]. If the taxpayer’s investments continued to grow, this trend would continue and he or she would avoid the 10% penalty.

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.

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