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October 20, 2002 at 08:00 PM
Rumors have been circulating in recent months that the IRS would issue 72(t) guidance providing taxpayers with a little more flexibility for payout modifications.
In guidance issued Oct. 3, the Treasury Department tossed a bone to taxpayers whose battered IRA holdings are threatened by 72(t) payouts at levels that are no longer realistic in todays markets. It was little consolation; the new rules allow account holders to make a one-time election to change the calculation method to the “required minimum distribution (RMD) method,” which will dramatically decrease payouts.
The basic principle of Section 72(t) is that payouts from an IRA or qualified plan before age 591/2 are subject to a 10% penalty, unless they are subject to one of numerous exceptions set forth in the Code. One of the best known exceptions is for a series of substantially equal periodic payments, commonly known as 72(t) payouts.
Since 1989, there have been three IRS-sanctioned safe harbor methods for calculating these payments. The new guidance retains the methods, but makes some modifications to them.
The biggest disadvantage of starting a 72(t) payout is that the Internal Revenue Code requires the payments to continue for the longer of five years, or until age 591/2. If the payment series is modified before the duration of this period (other than as a result of the owners death or disability), the individual will be subject to the 10% penalty on all amounts received, even in earlier years. Consequently, the question of what constitutes a “modification” becomes crucial when life intervenes with unexpected circumstances.
Under the first method (the RMD method), payouts are calculated in the same manner as would be required if the taxpayer were receiving minimum distributions under IRC Section 401(a)(9).
Changes to the RMD regulations in 2001 and 2002 have reduced the distribution amounts that result from this method, and even before those changes, the RMD method produced by far the lowest distribution levels of the three methods.
For this reason, this method has not been popular. But one of the most important advantages of this method is that the payout amount is redetermined each year, based on the account balance. This means that if the accounts value drops, the payout drops too.
The second method, known as the amortization method, takes interest rates and life expectancies into account to calculate a yearly distribution that amortizes the funds over the life of the owner. The 1989 guidance required only that a “reasonable” interest rate be used, but the new guidelines specify a benchmark based on the AFR (applicable federal rate). This reduces the ability of advisors to be creative with interest rate assumptions in tailoring the payouts to desired levels.
