IRS Code Section 72(t)

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What is the additional income tax under section 72(t)(1) of the Internal Revenue Code?

Section 72(t)(1) provides that an additional tax of 10 percent will be imposed on the amount includible in income with respect to a distribution from a qualified retirement plan as defined in section 4974(c). Various exceptions to this tax are set forth in section 72(t)(2).

What is the exception in section 72(t)(2)(A)(iv)?

Section 72(t)(2)(A)(iv) provides, in part, that if distributions are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancy) of the employee and beneficiary, the tax described in section 72(t)(1) will not be applicable. Pursuant to section 72(t)(5), in the case of distributions from an IRA, the IRA owner is substituted for the employee for purposes of applying this exception. Section 72(t)(4) provides that if the series of substantially equal periodic payments that is otherwise excepted from the 10-percent tax is subsequently modified (other than by reason of death or disability) within a 5-year period beginning on the date of the first payment, or, if later, age 59½, the exception to the 10-percent tax does not apply, and the taxpayer's tax for the year of modification shall be increased by an amount which, but for the exception, would have been imposed, plus interest for the deferral period.

Has the Service issued guidance on this exception?

Yes. In Q&A-12 of Notice 89-25, 1989-2 C.B. 662, the Service published guidance with respect to certain types of plans. In particular, Q&A-12 of Notice 89-25 pertains to individual account plans (including tax-sheltered annuities under section 403(b)) and individual retirement arrangements (both individual retirement accounts and individual retirement annuities). Q&A-12 of Notice 89-25 sets forth three methods that may be used in determining what are substantially equal periodic payments for purposes of section 72(t)(2)(A)(iv) of the Code. These are (1) a variable method, which is the required minimum distribution method, (2) a fixed amortization method, and (3) a fixed annuity method.

Are there new rules that may be used for calculating substantially equal periodic payments under section 72(t)(2)(A)(iv)?

Yes. These new rules can be found in Rev. Rul. 2002-62, 2002-42 I.R.B. 710 , which was made public on October 3, 2002, before its publication in issue 2002-42 of the Internal Revenue Bulletin on October 21, 2002. Rev. Rul. 2002-62 consolidates the descriptions of the methods in one place and describes the components of the various methods.

Generally, when are these rules effective?

The rules are effective for all payments commencing on or after January 1, 2003. However, see Q&A-9 for a transitional rule.

What are the components of the required minimum distribution method?

The required minimum distribution method consists of an account balance and a life expectancy (single life or uniform life or joint life and last survivor each using the age(s) attained in the year for which distributions are calculated). The annual payment is redetermined for each year.

What are the components of the fixed amortization method?

The fixed amortization method consists of an account balance amortized over a specified number of years equal to life expectancy (single life or uniform life or joint life and last survivor) and a rate of interest that is not more than 120 percent of the federal mid-term rate published in revenue rulings by the Service. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years.

What are the components of the fixed annuitization method?

The fixed annuitization method consists of an account balance, an annuity factor, and an annual payment. The age annuity factor is calculated based on the mortality table in Appendix B of Rev. Rul. 2002-62 and a rate of interest that is not more than 120 percent of the federal mid-term rate published in revenue rulings by the Service. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years.

If an individual began receiving substantially equal periodic payments before calendar 2003 using one of the three methods in Notice 89-25, may that individual continue with that method on or after January 1, 2003?

Yes. For example, if a 50-year-old individual began receiving substantially equal periodic payments in 1999 using the fixed amortization method, the fixed stream of periodic payments may continue under that method.

If an individual begins receiving substantially equal periodic payments using a fixed method on or after January 1, 2003, may that individual change to the required minimum distribution method?

Yes. If an individual begins receiving payments under either the fixed amortization method or the fixed annuitization method, that individual may change to the required minimum distribution method in a subsequent year. However, under Rev. Rul. 2002-62 once a change is made that change must be followed in all subsequent years.

How are interest rates determined?

The interest rate that may be used is any interest rate that is not more than 120 percent of the federal mid-term rate (determined in accordance with section 1274(d) of the Code for either of the two months immediately preceding the month in which the distribution begins). These interest rates are published by the Service in revenue rulings; they are cumulatively available within the Index of Applicable Federal Rates.

How is life expectancy determined?

The life expectancy tables that can be used are (1) the uniform life table in Appendix A of Rev. Rul. 2002-62, (2) the single life expectancy table in §1.401(a)(9)-9, Q&A-1 of the Income Tax Regulations or (3) the joint life and last survivor table in § 1.401(a)(9)-9, Q&A-3 of the regulations.

How is the account balance determined?

The account balance may be determined in any reasonable manner that is used consistently.

How are annual, substantially equal periodic payments determined for purposes of the required minimum distribution method, the fixed amortization method and the fixed annuity method?

An example of the required distribution method, an example of the fixed amortization method and an example of the fixed annuity method using the methodologies described in Rev. Rul. 2002-62 are set forth.

Facts:

Mr. B is the owner of an IRA from which he would like to start taking distributions beginning in 2003. Mr. B will celebrate his 50th birthday in January 2003. Mr. B would like to avoid the additional 10% tax imposed on early distributions under section 72(t)(1) by taking advantage of the exception in section 72(t)(2)(A)(iv) for distributions in the form of substantially equal periodic payments.

Assumptions:

* the account balance of Mr. B’s IRA is $400,000 as of December 31, 2002, and this is the account balance (and, when applicable, the date as of which the account balance is determined) used to calculate distributions.
* 120% of the federal mid-term rate for the appropriate month is assumed to be 4.5% and, when applicable, this is the interest rate that will be used for calculations.

What is an example of a one-time change from a fixed amortization method to the required minimum distribution method?

Facts and Assumptions:

Mr. S started receiving distributions from his IRA in the form of annual substantially equal periodic payments in 1998 at age 50. His annual payment ($97,258) had been originally calculated using the amortization methodology, with the same amount distributed each year. Following a steep decline in his IRA account balance from $1,400,000 in 1998 to $750,000 in 2002, Mr. S would like to use the special rule allowing a one-time change to the required minimum distribution method provided in section 2.03(b) of Rev. Rul. 2002-62 to determine a new annual distribution amount for 2002. For this one-time change in method, Mr. S will determine an annual distribution amount for 2002 using his IRA account balance on September 30, 2002 ($750,000), and a single life expectancy of 30.5 (obtained from Q&A-1 of § 1.401(a)(9)-9 of the Income Tax Regulations when an age of 54 is used).

Under the new method, the annual distribution amount for 2002 is $24,590.16 ($750,000/30.5). Mr. S must use the required minimum distribution method to determine the annual distribution amount for subsequent years.

What is the effect of an account being completely depleted?

If an individual's assets in an individual account plan or an IRA are depleted, the individual will not be subject to the income tax of section 72(t)(1) of the Code as a result of not receiving substantially equal periodic payments. In addition, the recapture tax described in section 72(t)(4) of the Code will not be applicable.

Are the methods contained in Rev. Rul. 2002-62 the only acceptable methods of meeting section 72(t)(2)(A)(iv) of the Code?

No. Another method may be used in a private letter ruling request, but, of course, it would be subject to individual analysis.