Tax Planning for Retirees

Penalty on Early Distributions from an IRA, Plan, or Annuity

Periodic Payments that Avoid the 10 Percent Penalty on Early Distributions. – The 10 percent penalty on early distributions under annuities, IRAs, or retirement plans does not apply to certain substantially equal periodic payments over (i) a retiree’s lifetime or life expectancy or (ii) the joint and surviver lifetimes or life expectancies of the retiree and beneficiary. The IRS provides three alternative methods for safely computing substantially equal periodic payments. These methods are available to a retiree if he or she receives periodic payments from a retirement plan, an IRA, or under a personally purchased annuity. (Notice 2004-15, 2004-9 I.R.B. 526.) See Chapters 2, 5, 10, and 16 of the treatise for discussions of the 10 percent penalty tax on early distributions.

Increasing Payments Nullify the Substantially Equal Exception to Early Distribution Penalty. – The tax law strictly defines substantially equal payments for purposes of qualifying for the exception to the 10 percent penalty tax on premature distributions. For example, the IRS has ruled that annuity payments that automatically increase each year by a fixed percentage will not qualify for the exception (even if the payments satisfy the requirements for minimum distributions). (Ltr. Rul. 201120011.) See Chapters 2, 5, and 16 of the treatise.

Avoidance of Early Distribution Penalty on Substantially Unequal Distributions. – The taxpayer applied his own method for taking “substantially equal” IRA distributions, in an attempt to avoid the 10 percent penalty on early distributions. Subsequently, the IRS ruled the distributions were not “substantially equal” and had resulted in excessive distributions. Nevertheless, the IRS waived the expired 60-day rollover period for the excess distributions and allowed the taxpayer to roll them back into his IRA without penalty. (Ltr. Rul. 200442033; similarly, Ltr. Rul. 200419031.) For descriptions of other situations where the IRS has waived the 60-day rollover requirement, click here. Also, see Chapter 5 of the treatise for discussions of (a) IRA rollovers and (b) the 10 percent penalty for early IRA withdrawals.

Early Distribution Penalty on Nonpayment of Plan Loan Due to Bankruptcy Proceedings. – A “qualified” loan from a retirement plan is not taxable when a retiree receives the loan proceeds. However, if the retiree fails to make an installment payment when due (including any grace period for payment), the tax law treats the entire outstanding balance of the loan as a taxable distribution. In a summary opinion, the Tax Court determined that the 10 percent penalty on early distributions could apply to such a deemed distribution even though the taxpayer was
precluded from repaying the loan due to bankruptcy proceedings. White v. Commissioner, T.C. Summary Opinion 2005-62.

Relief from Penalty on Early Distributions to a Public Safety Employee from a Governmental Plan. –Effective August 17, 2006, the Pension Protection Act reduces from 55 to 50 the retirement age at which the 10 percent early distribution penalty will not apply to distributions from a “governmental defined benefit plan” to a retired “ qualified public safety employee.” For this purpose, a governmental defined benefit plan generally means a government plan that provides retirement benefits that do not depend solely on discretionary contributions made to an employee’s individual account. A qualified public safety employee is one who provides police protection, firefighting services, or emergency medical services within the jurisdiction of the governmental unit sponsoring the plan.

Effective for tax years after 2015, the age reduction from 55 to 50 for qualified employees applies to distributions from all governmental qualified plans (not just defined benefit plans). The benefit of the age reduction is also extended to Federal law enforcement officers, firefighters, air traffic controllers, customs and border protection officers, and certain other Federal employees. Furthermore, distributions to a qualified public safety employee are not modifications of substantially equal payments that will trigger the 10 percent early distribution penalty.

See Chapters 2 and 4 of the treatise for a more complete discussion of the penalty on early plan distributions and its exceptions. (Pension Protection Act of 2006, Pub. L. No. 109-280, § 828(a), (b); I.R.C. § 72(t)(10).)

Effect of Trustee Error on the Penalty Tax for Premature Distributions. – Generally, the penalty tax on premature distributions will retroactively apply to payments made under the exception for substantially equal payments if the payment schedule is modified before the later of (1) age 59 ½ or (2) five years after the first payment. However, the IRS has ruled that failure to make a substantially equal payment until the year after it was due did not constitute a modification when the failure was due to trustee error. (Ltr. Rul. 200835033.) On the other hend, a modification generally occurs upon the rollover to another IRA of part or all of the funds providing the substantially equal payments. (Ltr. Rul. 200925044.) Nevertheless, a modification generally does not occur upon a trustee-to-trustee transfer of the funds to another IRA that continues the substantially equal payments. (Ltr. Rul. 200929021.) See Chapters 2, 4, 5, and 6 of the treatise for an explanation of the penalty tax on premature distributions.

No Premature Distribution Penalty on Birth or Adoption Distributions. – After 2019, the 10 percent penalty on premature distributions from tax-favored plans will not apply to up to $5,000 of distributions occasioned by birth or adoption of a child. The $5,000 limit applies separately to each parent with respect to that parent’s distributions from his or her plans or IRAs. The new provision also allows for later recontribution of the distributions to the taxpayers’ qualified plans and IRAs. The IRS has also announced that, if an eligible plan does not authorize qualified birth or adoption distributions, an individual who receives a permitted in-service distribution that meets the requirements of a qualified birth or adoption distribution may nevertheless treat the distribution as a qualified birth or adoption distribution. The distribution, while includible in gross income, is not subject to the early distribution penalty. The individual may recontribute the amount to an IRA without regard to the usual 60-day rollover requirement. (The SECURE Act of 2019, Pub. L. No. 116-94, § 113; Notice 2020-68, 2020-38 I.R.B. ___.) See Chapters 2, 4, and 5 of the treatise.

Applicability of Early Distribution Penalty to Annuities Held in Trust. – The IRS has ruled that, if a retiree uses a grantor trust to purchase an annuity for a beneficiary, the early distribution penalty will not apply to annuity distributions to the beneficiary after the retiree (the grantor) reaches age 59½ or becomes disabled. Further, the life or life expectancy of the grantor must be used to qualify for the substantially equal payments exception to the penalty. If instead a nongrantor trust is established and purchases the annuity for a beneficiary, the retiree is not the owner of the trust and thus the age 59½, disability, and substantially equal payment exceptions do not apply. However, for both a grantor trust and a nongrantor trust, it is the death of the primary beneficiary (and not the death of the grantor) that will also allow annuity payments without penalty. (I.R.C. § 72(u)(1), 72(s)(6)(B), 72(q)(2)(A), (B), (C), (D); Priv. Ltr. Rul. 202031008.) See Chapter 16 of the treatise for a more complete discussion of the taxation of personally purchased annuities.