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Treasury Tosses A Bone To Taxpayers With 72(t) Modifications

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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.

The third method, the annuity method, makes use of interest rate assumptions and a mortality table to determine an annuity factor, representing the present value of an annuity of $1 per year beginning at the taxpayers age in the first year and continuing for life. (Most people need software to do this calculation.)

Rather than allowing the use of “reasonable” interest rates and mortality tables, the new guidance specifies the benchmark interest rates (based on the AFR, as noted above), and includes a required mortality table. Again, this greatly reduces the flexibility formerly available at the establishment stage of a 72(t) payout.

The main purpose of the new guidance is to provide a one-time election for taxpayers wishing to switch methods, from the annuity or amortization method to the RMD method. The effect of this election will be to greatly reduce the 72(t) payout amounts.

Example: Assume that Chad was laid off in 2000, when he was age 50 and owned a $500,000 IRA. Chad took a lower-paying job and started a payout of $30,000 annually from his IRA to supplement his income. But today, his IRA value has dropped to $300,000. If Chad continues the existing payout until he is 591/2, the funds will be inadequate to meet his retirement needs. If he makes the one-time election in 2002, at age 52, the payout under the RMD method will drop to $6,726.

Although the RMD method involves calculating a distribution each year based on the current account balance (in other words, the payout will fluctuate with market results), the election locks taxpayers into a method that inherently produces much lower payouts.

In the past, the amortization and annuity methods have been very popular. Some private rulings have permitted the use of annual recalculation under these methods, or cost of living adjustments. The new guidance ignores these techniques; in fact, the Service states that the amortization and annuity methods both produce a fixed annual payout amount that does not change from year to year.

In the “thanks a lot” category, the Service does mention that if taxpayers stick with their old payout and their account becomes depleted before the duration requirement has been met, the IRS will not impose the 10% penalty for the modification of the payment series that results from the account reaching zero. (The number of this ruling is Revenue Ruling 2002-62.)

April K. Caudill, J.D., CLU, ChFC, is managing editor of Tax Facts & ASRS, publications of The National Underwriter Company.

Reproduced from National Underwriter Life & Health/Financial Services Edition, October 21, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.