Planning to Avoid the Premature Distribution Penalty

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The Benefits and Disadvantages of IRC Section 72(t)

Saving for retirement represents a common objective of most taxpayers. Congress has allowed individuals to fund many different types of retirement plans with significant annual contributions (e.g., individual retirement accounts [IRA], Internal Revenue Code [IRC] section 403 [b] plans, 401[k] plans, Keogh accounts, pension plans, profit-sharing plans, money-purchase pension plans). Recent federal fiscal outlays, such as the $700 billion bailout of financial institutions under the Emergency Economic Stabilization Act of2008, make it conceivable that Social Security distributions available to future retirees will be significantly reduced. Thus, it is more critical than ever for individuals to try to save as much as possible for their own retirement.

Income tax provisions related to retirement plans have become extremely complex-and, at times, nearly incomprehensible. Individuals and their tax advisors should acquaint themselves with the options available in order to plan for IRA distri- butions that avoid a common pitfall in retirement planning: the penalty for premature distributions.

Premature Distributions

Most retirement plans allow for either a current income tax deduction or W-2 income reduction in the amount of the contribution to the plan. In addition, the investments in these plans build up tax free until the time of distribution. This immediate income tax deduction, coupled with the tax-free buildup, makes such retirement plans one of the most useful investment vehicles available to taxpayers. All is well as long as the taxpayer does not need these funds until retirement, because Congress imposes a 10% penalty on early distribution from these plans in order to ensure that the money is used for its intended purpose of providing retirement income to the account owner (IRC section 72[t][l]).

Another penalty of 50% applies to taxpayers who fail to make required distributions upon turning age IOV2 (IRC section 409[a] [9]). The government imposed the 10% penalty to help ensure that taxpayers would not tap into their retirement accounts until after retirement (i.e., after age 5914), but also would not structure their retirement accounts to permanently escape taxation; thus, the 50% penalty motivates taxpayers to make the required minimum distributions (RMD).

Yet, life does not always work out as planned. What if a taxpayer needs to tap into these funds prior to retirement for valid reasons? Should this penalty apply? Taxpayers might need funds because they lost their job, lost a loved one, encountered unexpected medical or educational expenses, or went through a divorce. In addition, taxpayers might need funds due to a severe economic disruption, such as the current ongoing crisis.

There are several ways for taxpayers to receive limited amounts of distribution from their retirement plans penalty free. Even though amounts might qualify for penalty-free distribution, they are usually subject to income taxation. This discussion will introduce several available methods of receiving penalty-free distributions from an IRA, as well as exceptions to the penalty; it will also focus on the substantially equal periodic payment (SEPP) method for avoiding the penalty on premature distributions, the general requirements to qualify for the SEPP method, the calculations made under this method, the SEPP method's advantages and disadvantages, IRS filing requirements, and planning opportunities for taxpayers and their financial advisors.

Penalty Exceptions

As mentioned above, IRC section 72(t)(l) provides for a 10% penalty on the amount of premature retirement plan distribution included in a taxpayer's gross income. A distribution is considered to be premature if it does not meet one of the exceptions under IRC section 72(t). Congress has provided fairly liberal exceptions to this penalty, including distributions that are-

* made on or after the taxpayer attains the age of 591/2 (IRC section 72[t][2][A][i]);

* made to a beneficiary (or to the estate of an employee) on or after the employee's death (IRC section 72 [t] [2] [A] [ii]);

* attributable to the taxpayer becoming disabled, within the meaning of IRC section 72(m)(7) (IRC section 72[t][2][A][iii]);

* part of a series of substantially equal periodic payments-not less frequently than annually-made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and a designated beneficiary (IRC section 72 [t] [2] [A] [iv]);

* made to an employee after separation from service after the age of 55 (IRC section 72[t][2][A][v]);

* made on account of a levy under IRC section 6331 on the qualified retirement plan (IRC section 72 [t] [2] [A] [vii]);

* made to the employee for amounts paid during the taxable year for medical care, determined without regard to whether the employee itemized deductions for that taxable year (IRC section 72[t][[2][B]);

* made to alternate payees pursuant to qualified domestic relations orders (IRC section 72[t][2][C]);

* made to unemployed individuals for health insurance premiums (IRC section 72[t][2][D]);

* made from individual retirement plans for higher education expenses, not to exceed the amount of those expenses (IRC section 72[t][2][E]);

* made from certain plans for first-time home purchases less than or equal to $10,000 (IRC section 72[(t][2][F]); or * made to individuals called to active duty (IRC section 72[t][2][G]). …