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).