In the current economic climate, unexpected circumstances may cause many individuals to consider the early withdrawal of IRA funds. Minimizing the tax consequences of these withdrawals requires careful consideration of opportunities to avoid the 10% penalty on premature distributions.
While all distributions from a traditional IRA are subject to income tax under the annuity rules in IRC § 72, an additional 10% penalty is imposed by section 72(t) on the taxable portion of distributions occurring before the owner reaches age 59½. The IRA owner can avoid this penalty if specific exceptions apply.
For example, the penalty does not apply to withdrawals due to the owner’s death or disability. Distributions for qualified medical expenses, qualified education expenses, first-time home purchases, and health insurance premiums paid by the unemployed, as well as qualified hurricane distributions and qualified reservist distributions for the military, are all exempt from the penalty (subject to certain requirements). Distributions that are part of a qualified series of substantially equal periodic payments (SEPPs) made annually to the IRA owner are also exempt from the penalty.
Of all the exceptions to avoid the early distribution penalty, the substantially equal periodic payment (SEPP) alternative is the most universally available. It does not rely on pre-existing conditions such as medical or educational expenses and is available to any IRA owner who is willing to calculate and sustain withdrawals according to the rules specified by the IRS. Thus it provides an opportunity to fund early retirement or meet payments on long-term debt obligations without the imposition of the penalty. This can mean substantial savings on large IRA withdrawals.
DEVELOP A STRATEGY
The IRS provides several safe-harbor methods for calculating the SEPP amount. Some factors are subject to the taxpayer’s discretion and may be used to adjust the payment to a preferred amount and still avoid the premature distribution penalty. Using these factors to establish the SEPP amount in response to the IRA owner’s objectives requires making choices at the beginning of the payment series.
For example, a client wishing to meet short-term financial needs with IRA distributions may prefer to maximize the SEPP withdrawal over the shortest possible period. This objective would be met by choosing among several approved formulas, interest rates, and life expectancies to calculate the maximum payment.
However, if the objective is to fund a long-term commitment such as early retirement, the client may prefer to limit the payment amount to extend the series over a lengthy period. In this case the same factors could be used to maximize the distribution period. Strategic choices made in establishing the SEPP will permit the IRA owner to exercise some control over the amount to be received consistently over the payout period.
For a detailed discussion of the issues in this area, see the article by Linda Burilovich and Andrew Burilovich, “Substantially Equal Periodic Payments from an IRA,” in the October 2008 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following topics in the October 2008 issue of The Tax Adviser:
A discussion of deductible commuting expenses.
A look at recent S corporation developments.
An examination of how to terminate partnership interests.
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