Early Withdrawal Penalty Relief - 72 t - Tax Law Changes - Qualified Retirement Plans - IRA

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Limited Relief From Early Withdrawal Penalty

IRC Section 72(t) provides that if an individual receives any amount from a qualified retirement plan before attaining age 59½, the individual's income tax is subject to the 10 percent penalty unless an exception applies. For this purpose a qualified retirement plan includes:

a Section 401 plan,
a Section 403(a) annuity plan,
a Section 403(b) tax sheltered annuity arrangement,
an IRA, and
an IRA annuity

This penalty has become known as the early distribution penalty.

Section 72(t)(2)(A)(iv) provides an exception to the early distribution penalty. This exception is for payments that are part of a series of substantially equal periodic payments made 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.

The series of payments may not be modified (other than by reason of death or disability) within a five-year period beginning on the date of the first payment or, if later, age 59½. This series of payments has become known as 72(t) payments.

Guidance was provided in Q&A -- 12 of IRS Notice 89-25 on how to calculate 72(t) payments. In that guidance, the IRS identified three calculation methods:

the minimum distribution method
the amortization method
the annuitization method

Under the amortization and annuitization methods, the same amount of money must be taken out every year throughout the series. Under the minimum distribution method, the payment amount varies each year during the series, based changing account values and decreasing life expectancies.

A few years ago when the Dow Jones Industrial Average was above 10,000 and their IRAs were worth considerably more than they are today, thousands of people under age 59½ began withdrawing from their IRAs under the amortization and annuitization methods. For most, it was a last resort: They had been laid off, were unable to find a new job and had no other source of money to pay their bills. Although they owed income tax on their IRA withdrawals, at least they could avoid the 10 percent penalty.

Then the stock market began its painful decline, and many of these folks now face the real possibility that they will wipe out most of their retirement savings in a not too far distant future.

But thanks to the IRS ruling (Rev. Rul. 2002-62), individuals in this situation can slow down their IRA withdrawals to help preserve what's left in their IRA accounts. The IRS will now allow them to change from one of the two fixed withdrawal methods to the minimum distribution method and this will not trigger the 10 percent penalty. However, the minimum distribution method must be used for all subsequent years. If the participant later changes from the minimum distribution method to the amortization method or annuitization method, that subsequent change is treated as a modification under IRC Section 72(t)(4).

Another change deals with the interest rate for the 72(t) calculations. Both the amortization method and the annuitization method require the taxpayer to choose an interest rate. Rev. Rul. 2002-62 allows the use of any interest that is not more than 120 percent of the federal mid-term rate. This is consistent with numerous private letter rulings that have been issued by the IRS over the last several years.

Effective date. The guidance in Rev. Rul. 2002-62 replaces the guidance in Q&A-12 of Notice 89-25 for any substantially equal payment that commences on or after January 1, 2003. If distributions commenced before 2003, the calculation method may be changed to the minimum distribution method at any time without being treated as a modification, including the use of a different life expectancy table at the time of the change.

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