Advanced Underwriting Consultants

Question of the Day – December 26th

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Here’s the question of the day.

Question:  My client is 56 and she owns a nonqualified deferred annuity (NQDA).  She wants to surrender the contract, but is worried about the 10% penalty tax on distributions.  May she transfer the annuity to her 60 year old husband, and can he avoid the penalty tax on surrender?

Answer:  Apparently yes, if the annuity carrier permits the transfer of the contract.

A change in ownership of a nonqualified annuity contract from one spouse to another is a nontaxable transfer under Code Section 1041. The age of the policy owner is used to determine whether the taxable portion of an NQDA distribution is subject to the penalty tax.  While if the wife surrendered the annuity in the example described, she would have to deal with the penalty tax, a surrender of the contract by the husband would be exempt.

There are no IRS letter rulings or other tax authorities preventing this technique, nor are they any waiting periods apparently imposed.  It is possible that the IRS, presented with these facts, might try to impose the step transaction doctrine to apply the penalty tax, but in our opinion that seems unlikely.

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Question of the Day – October 5

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Here’s the question of the day.

Question:  My client owns a deferred annuity.  She will turn 59 ½ later in this calendar year.  If she takes a taxable withdrawal now, is she subject to the penalty tax?

Answer:  Yes.  Early taxable distributions are subject to the 10% penalty tax unless a specific exception applies.  The age 59 ½ exception is strictly construed.

Here’s the critical language from Revenue Code Section 72(q):

    (q) 10-percent penalty for premature distributions from annuity
        contracts
      (1) Imposition of penalty
        If any taxpayer receives any amount under an annuity contract,
      the taxpayer's tax under this chapter for the taxable year in
      which such amount is received shall be increased by an amount
      equal to 10 percent of the portion of such amount which is
      includible in gross income.
      (2) Subsection not to apply to certain distributions
        Paragraph 1 shall not apply to any distribution -
          (A) made on or after the date on which the taxpayer attains
        age 59 1/2,

The interpretation is the same for taxable distributions from an IRA or other qualified plan.  Here’s the IRS’s explanation of the penalty tax from Publication 590, which applies to IRA distributions:

Generally, if you are under age 59½, you must pay a 10% additional tax on the distribution of any assets (money or other property) from your traditional IRA. Distributions before you are age 59½ are called early distributions.

The 10% additional tax applies to the part of the distribution that you have to include in gross income. It is in addition to any regular income tax on that amount.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – September 10

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Here’s the question of the day.

Question:  My 51 year old client is retiring from the police force this year.  If he takes money out of his 403b plan after retirement, is the distribution subject to the 10% penalty tax?

Answer:   Probably not.  There is a special exception to the 10% penalty tax for public safety employee retirees.  If a distribution is taken by a participant who retired from the employer sponsoring the plan at age 50 or later, then the distribution is exempt from the penalty tax.  The distribution is still subject to ordinary income tax.

Note that the special exception will be lost if the 403b plan balance is rolled over to an IRA.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – July 9

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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 53, and wants to avoid the 10% penalty tax on her IRA distributions.  Will the IRA custodian help her with calculated 72(t) distributions?

Answer: Some of them will, but it is not a requirement.

The Internal Revenue Code provides that taxable distributions from an IRA to a taxpayer younger than 59 ½ are subject to an extra 10% penalty tax unless there is a special exception.  One such exception is that the 10% penalty tax does not apply to distributions which are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the individual or the joint lives or joint life expectancy of the individual and his designated beneficiary.  This is sometimes referred to as the 72(t) exception.

Once a taxpayer begins to take 72(t) distributions, the taxpayer must continue them for the longer of five years or until the taxpayer reaches age 59 ½.  If the taxpayer modifies the 72(t) distribution stream—perhaps by taking greater or lesser distributions from the IRA than those required under the 72(t) distribution strategy—all prior distributions intended to meet the 72(t) requirements will be subject to the penalty tax.

Some IRA custodians actively help their customers calculate and take 72(t) distributions.  Others do not support 72(t) at all.

If working with a client who intends to take 72(t) payments, we recommend that the advisor check with the IRA administrator to determine their willingness to actively participate in the 72(t) process.  For those administrators that will not help calculate 72(t) payments, the advisor should find out how the administrator will report distributions to the IRS on Form 1099-R for income tax purposes.

From the client’s perspective, it would be most helpful for 72(t) distributions to be coded as taxable distributions which are not subject to the penalty tax.  On Form 1099, that means that box 7 will have distribution code 2.

While Form 1099-R does not bind the IRS to accept that the distributions conform to 72(t), the proper 1099 coding makes it administratively easier on the taxpayer who is taking 72(t) payments.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – October 31

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Here’s the question of the day.

Question: My 40 year old client is applying to take a hardship withdrawal from her 401K plan.  Is the distribution subject to the 10% penalty tax?

Answer: Yes, the taxable part of a 401K plan distribution is subject to the penalty tax unless one of the exceptions applies.  Here are the most common exceptions:

  • Death of the participant
  • Disability of the participant
  • Part of a series of substantially equal payments based on life expectancy
  • Taken by a participant who retired from the employer sponsoring the plan at age 55 or later
  • Distribution was used to pay for certain limited costs for medical care

Note that the 401K penalty tax exceptions do not include provisions for first time homebuyer or education expenses.

Hardship withdrawals may be made from a 401(k) plan only for an immediate and heavy financial need.  Financial need is not an exception to the 10% penalty tax.

If the client needs money, and is worried about the income tax consequences of a hardship withdrawal, a loan may be a better option if the plan permits it.  Loans are not considered taxable distributions at all.  However, if the plan permits a loan

  • The loan must be real and documented,
  • The maximum amount of the loan is the lesser of half the vested portion of the account or $50,000, and
  • The loan must be repaid under a regular amortization schedule not to exceed five years.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.