Question: If my client activates the income rider on my annuity, does that qualify for the substantially equal periodic payments exception to the early distribution penalty?
Answer: Not necessarily.
The IRS gives us three methods under Code Section 72(t) to determine substantially equal periodic payments in order to avoid the 10% additional tax on distributions taken from qualified accounts before age 59 ½. The methods can be found in Revenue Ruing 2002-62, they are:
- Required minimum distribution method
- Amortization method
- Annuitization method
Each of these methods requires its own calculation based upon the account value and the life expectancy of the account owner. Simply receiving a set amount each year from an income rider does not necessarily meet these calculation requirements.
The payments from the income rider would have to exactly equal to the Section 72(t) substantially equal periodic payments determined by one of these methods to qualify as an exception to the additional tax on early distributions.
There is a free calculator for Section 72(t) distributions at http://72t.net/72t/Sepp/Calculators.
Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.
Question: My client is 56 years old and has incurred substantial medical bills this year, which he paid out of pocket. Can you explain how the medical expense exception to the 72(t) ten percent penalty works?
Answer: The exception is found in Section 72(t)(2)(B) of the Internal Revenue Code. The amount he incurs on medical expenses in excess of 10 percent of his adjusted gross income may be distributed from his retirement plan penalty-tax-free. Here’s a formula that might help:
Amount of distribution not subject to penalty = Medical Expenses – (10% × AGI)
For example, if your client’s income last year was $70,000, and he incurred $15,000 in medical expenses, he may withdraw up to $8,000 without incurring a penalty (i.e. $15,000 medical expenses less $7,000 threshold amount). Keep in mind, however, that he would still incur ordinary income tax on the full $15,000 distribution.
What medical expenses count toward how much you may distribute? The list is quite inclusive and can be found in the IRS’s Publication 502, but here are a few that might be particularly relevant:
- Payments of fees to doctors and other medical practitioners;
- Payments for hospital care; drug addiction treatment;
- Payments for weight-loss programs, prescription drugs and insulin;
- Payments for admission and transportation to a medical conference relating to a chronic disease that you have;
- Payments for reading or prescription eyeglasses, contact lenses, hearing aids, crutches, wheelchairs, false teeth, and guide dogs for the blind or deaf; and
- Payments for transportation for qualified medical care.
Additionally, qualified medical expenses include those your client pays on behalf of his spouse or dependent.
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