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: I have a client who wants to access money from her IRA prior to age 59 ½.  How can she avoid the 10% premature distribution penalty on money she receives?

Answer: To avoid the penalty, many take distributions that are “part of a series of substantially equal periodic payments (sometimes called a SEPP) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his designated beneficiary.”  See Revenue Code Sec.72(t)(2)(A)(iv).

The IRS issued Revenue Ruling 2002-62, addressing rules governing this exception to the 10% penalty.  The ruling sets out three acceptable methods for determining payments under a series of substantially equal periodic payments:

(1) the required minimum distribution (RMD) method,

(2) the fixed amortization method, and

(3) the fixed annuitization method.

Each of the three methods requires use of a life expectancy table. The taxpayer can elect

• the Uniform Lifetime Table,
• the single life expectancy table, or
• the joint and last survivor table.

Once chosen the table cannot be changed from year to year.

Methods (2) and (3) require the use of an interest rate assumption.  Revenue Ruling 2002-62 states that the interest rate used must not exceed 120% of the applicable mid-term rate for either of the two months preceding the month in which distribution begins.

Under the RMD method, the account balance is determined each year on a valuation date.  There is some flexibility in choosing the valuation date, but it is usually December 31.  The account balance is divided by the life expectancy determined from the applicable life expectancy table using the taxpayer’s age on the birthday falling within the distribution year. Using this method, there is a re-calculation of the payout each year.

Under the fixed amortization method, the initial account balance is determined.  That amount is amortized over the appropriate life expectancy using an interest rate not to exceed the limits set out above.  Once the initial payment is determined, it does not change but remains constant over the life of the arrangement.

Using the fixed annuitization method, an interest rate is selected (not to exceed the limits set out above) and using the appropriate mortality table, an annuity factor is derived.  The initial account balance is divided by the annuity factor and a payment determined.  Once determined, the payment does not change over the life of the arrangement.  The easiest way to get this number, in practice, is to ask a life insurance company for a quote.

Once a series of substantially equal periodic payments is commenced, it must continue for at least five years or until age 59-1/2, whichever comes last.  If the arrangement is terminated or the payments are changed prior to that time, the taxpayer will be assessed the 10% penalty plus interest for all payouts prior to the later of five years or age 59-1/2.

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