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Raiding Your IRA: |
Pension Memo |
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I have seen a rash of problems recently with people getting hit with the IRS 10% penalty for distributions from IRAs and plans before age 59-1/2. This penalty, which is imposed by Section 72(t) of the Internal Revenue Code, is paradoxical. On the one hand, unlike many other tax penalties, this one cannot be cancelled for "hardship" or "reasonable cause," no matter how compelling the circumstances. On the other hand, with only a little care and advance planning, the section 72(t) penalty can be safely avoided. In fact, the financial services industry has developed a cottage industry using the 72(t) exceptions as creative planning tools. When viewed this way, many paying the 10% early distribution penalty do so voluntarily. I have heard it called the "stupidity tax." Three factors are causing the current outbreak of the penalty. First, the rules under Code section 72(t) are complex and unforgiving. Second, clients are badly misinformed about the penalty and its exceptions. Third, as the baby boomers march toward retirement, they are dipping into their IRAs for tuition payments, mortgages on second homes, and seed money for new businesses. Background Distributions from IRAs and qualified retirement plans are subject to ordinary income tax. If the distribution is made before age 59-1/2, a 10% penalty (euphemistically called the "additional tax") is added on. Sounds simple enough, so why the problems? Section 72(t) is a quagmire that applies to qualified plans, IRAs, and 403(b) plans. It is several pages of opaque legalese that imposes the penalty and then sets out a hodgepodge of about a dozen exceptions. The exceptions are not uniformly applied among these three groups of retirement arrangements, so we end up with silly rules. For example, penalty free distributions for medical expenses can be made from plans, IRAs, and 403(b) plans, but penalty free distributions for medical insurance can be made only from an IRA and, even then, only if the individual is unemployed. The exception for pre-age 59-1/2 distributions applies to:
The IRS has not issued regulations for the section 72(t) penalty and its exceptions. The IRS guidance must be gleaned from private letter rulings, publications, and a few notices. The section 72(t) penalty, remarkably, has no statutory exceptions for "hardship" or "reasonable cause." Neither the IRS nor the courts have any authority to waive the penalty, even in the most sympathetic cases. Bad advice from an accountant, a plan administrator, an employer, or even the IRS itself is not sufficient to escape the penalty. Desperate financial necessity is irrelevant. However, there is relief in narrow cases where, due to circumstances beyond the control of the individual, an attempted rollover is botched because it violated the 60 day rule. See Rev. Proc. 2003-16. Two Groups Who Pay The section 72(t) penalty is paid by the desperate and the misinformed. The first category, the desperate, includes those individuals who, unfortunately, have no financial options. The penalty applies to hardship withdrawals from plans and participant plan loans going into default where the participant is under age 59-1/2. This category also includes those who, in financial desperation, simply use retirement money before 59-1/2 to simply live. There's not much we can do in these cases. The second category is the misinformed. Here are the true "voluntary" penalty payers, those who could have avoided the 10% penalty but did not. These folks have options, time to plan, and access to financial information, but simply blow it. Here are the three most common ways the penalty is sprung on the misinformed. 1. The most common mistake involves the exception for separation from service after attaining age 55. There are two traps within this exception. First, both the separation from service and the distribution must occur after age 55. You cannot separate at age 53, wait a few years and take a distribution at age 56. (However, if you separate at 54 and turn 55 during the same year, you will qualify.) Second, the distribution must come from a qualified plan, not an IRA. Here's how many penalties occur: the client leaves his job after age 55, takes a rollover from his 401(k) to his IRA (because that seemed like the right thing to do at the time), then later takes the distribution from the IRA. 2. The disability exception looks easy to satisfy, but it's not. The disability must be "total." The distribution must also be "attributable" to the disability. Grabbing some of your IRA money before 59-1/2 because you have a head cold is not enough, but many have tried and paid the penalty. 3. Some clients use their IRAs to fund their new businesses or to make loans to family members. Some clients pledge their IRAs to secure personal or business loans. All of these will be deemed a distribution from the IRA under Code section 408(e), and if the IRA owner is under age 59-1/2, the 10% penalty under section 72 (t) applies. Avoiding the Penalty with SEPPs The irony of the section 72(t) penalty is how easy it is to avoid. One of the exceptions for the 10% 72(t) penalty is for distributions which are "part of a series of substantially equal periodic payments" (or "SEPPs") over the life of the participant and/or his beneficiary. With some planning, this exception is easy to satisfy and generously interpreted by the IRS. Given the draconian features of the penalty, it is hard to understand why this exception exists or why the IRS is so lenient in its application. But, there it is. In a nutshell, if you annuitize your IRA before age 59-1/2 and do so for at least five years and continue beyond 59-1/2, the penalty can be avoided. The IRS has issued a lot of guidance on setting up a qualifying distribution arrangement (Revenue Ruling 2002-62) and there are many private letter rulings that take you through all the steps. The key to a successful SEPP withdrawal program is planning. The SEPP exception has its own set of traps. Clients who cobble together their own SEPP program without help from their lawyer, CPA, or financial planner almost always screw it up. On the other hand, I have never had a client encounter any problems with a SEPP program if they had professional help. A few fine points about the SEPP should be kept in mind. The SEPP withdrawals should be made from IRAs, not qualified plans. If made from a plan, there must first be a separation from service. The "separation from service" requirement for SEPPs does not apply to IRAs. IRAs should be specially funded and designed for the SEPP distributions. There is a major trap if the SEPP distribution program is "modified" before completion, as the exception is lost retroactively and the penalty will apply to all prior years. There's a wealth of information about SEPP distributions. A Google search under "72(t)" will produce over 32 million hits. The financial services industry has done an excellent job in offering information, on-line calculators, and examples of how this flexible exception works. Conclusion The 10% penalty for IRA and plan distributions before age 59-1/2 is harsh. But, with planning, the penalty can be avoided through a properly structured "substantially equal periodic payment" program set up with professional help. |
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© 2008 Eugene Parrs |
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