Substantially Equal Payment Exception

One of the most useful exceptions to the early distribution tax (particularly for IRA distributions before the taxpayer is age 59½) is the exception for substantially equal payments. This exception may prove useful in situations such as:

• When an individual expects to be in a higher tax bracket when distributions would normally begin; or
• When an individual retires early (or becomes unemployed) before reaching age 59½ and needs IRA distributions to meet living expenses.

For example, it may be years before the individual will be eligible for Social Security or other retirement benefits (if eligible at all), or such benefits may be sharply reduced if payments begin early.

To qualify under the substantially equal payments exception, the distribution must be part of a series of substantially equal periodic payments (SEPPs) made (at least annually) for the life (or life expectancy) of the individual or the joint lives (or joint life expectancies) of the individual and his or her designated beneficiary. However, distributions made under this exception do not need to actually continue for the life of the individual. Under Sec. 72(t)(4), payments may be altered (or stopped completely) after the later of:

• The date the individual turns age 59½; or
• The close of the five-year period beginning with the date the initial payment was received.

If payments are altered before this time (except on account of death or disability), the tax is applied retroactively (recaptured) in the first year the modification is made (i.e., the tax is the amount that would have been imposed on the current and all previous distributions had this exception not applied). The tax is applied only to the payments received before the taxpayer turned 59½, even if the recapture event occurs after this time (e.g., payments were changed before the end of the five-year period beginning with the date the initial payment was received but after the taxpayer turned 59½). In addition, the taxpayer must pay interest on the tax, beginning with the tax year the penalty would have been payable and ending on the actual payment date (Sec. 72(t)(4)(A)(ii)(II)).

Example 1: T retires at age 50 and begins receiving $10,000 annual IRA distributions (calculated to be spread evenly over his life expectancy). Assuming T neither dies nor becomes disabled, the $10,000 distributions (no more and no less) need to continue at least until he is age 59½ to avoid the early withdrawal penalty. After that he can modify or discontinue the distributions without incurring the penalty.

Example 2: Assume instead that T is 57 when he retires and begins his IRA distributions. Here, to avoid the early distribution penalty, distributions must continue unmodified for at least five years after he takes the first one.

Altering Distributions After Divorce

Although altering the payment before the end of the required payment period generally triggers the recapture tax, the IRS has allowed taxpayers who have divided IRAs due to divorce during this period to adjust their substantially equal payments without triggering the recapture tax. In Letter Ruling 9739044, the taxpayers divorced after substantially equal payments from three IRAs had begun. The IRAs were to be split equally between the spouses under the divorce agreement, and both spouses planned to continue to withdraw their respective shares of the payment as originally computed (i.e., total payments to the two of them did not change).

In Letter Ruling 200050046, the taxpayer’s ex-wife was awarded approximately one-third of his IRA. The IRS ruled that the husband was under no obligation to continue payments from the portion of the IRA awarded to his ex-wife and thus could reduce his annual payments to reflect his post-divorce share of his IRA without triggering the recapture tax.

Computing Substantially Equal Payments

Annual payments calculated under one of the following methods will be considered substantially equal periodic payments (Notice 89-25; Rev. Rul. 2002-62).

Minimum Required Distribution Method

Under the minimum required distribution method, the annual payment is determined using a method acceptable for calculating the minimum required distribution (MRD) under Sec. 401(a)(9). For this purpose, account owners have three life expectancy options: (1) the uniform lifetime table from Rev. Rul. 2002-62, Appendix A; (2) the single life expectancy table that appears in Regs. Sec. 1.401(a)(9)-9, Q&A-1; or (3) if there is a designated beneficiary, the joint life expectancy table that appears in Regs. Sec. 1.401(a)(9)-9, Q&A-3 (Rev. Rul. 2002-62, §2.02(a)).

Observation: Calculating the payment using the MRD method will result in relatively small payments. However, it is the only IRS-sanctioned method that allows an account owner to recalculate payments taking changing account balances into consideration. This will ensure that the account will last a lifetime. It also allows for increased distributions when the account investments do well.

Fixed Amortization Method

Under the fixed amortization method, the annual payment is determined by amortizing the account balance over a number of years equal to the individual’s life expectancy (or joint life expectancy of the individual and designated beneficiary) at an interest rate that “does not exceed a reasonable interest rate” (Notice 89-25, Q&A-12). For this purpose, account owners have the same three life expectancy options as under the MRD method. Also, any interest rate that is not more than 120% of the federal midterm rate for either of the two months immediately preceding the month in which the annuity-like withdrawals first commence will be considered reasonable (Rev. Rul. 2002-62, §2.02(c)).

The account owner calculates the amount to be distributed each year in the first year and does not recalculate it thereafter. However, the account owner can switch to the minimum distribution method at the beginning of any future year. Once the account owner makes the switch, he or she must use the minimum distribution method for the balance of the required payment period.

Observation: Calculating the payment under the fixed amortization method using an interest rate of 120% of the highest federal midterm rate for the previous two months and the single life table will result in the largest possible annual distribution. The account owner can use a lower interest rate (down to 0%) if he or she desires a smaller payment.

Fixed Annuity Factor Method

Under the fixed annuity factor method, the annual payment is determined by dividing the account balance by an annuity factor calculated using the mortality table in Rev. Rul. 2002-62, Appendix B, and an interest rate that “does not exceed a reasonable interest rate.” Once again, any rate that is not more than 120% of the federal midterm rate for either of the two months immediately preceding the month in which the annuity-like withdrawals first commence will be considered reasonable (Rev. Rul. 2002-62, §2.02(c)). The account owner calculates the amount to be distributed each year in the first year and does not recalculate it thereafter. However, the account owner can switch to the MRD method at the beginning of any future year. Once the account owner makes the switch, he or she must use the MRD method for the balance of the required payment period.

The annuity factor method will always result in a payment that is slightly less than that calculated under the amortization method using the same interest rate. Therefore, there is little reason to consider this method. If the maximum payment using the amortization method is too large, the account owner can use a lower interest rate or reduce the account balance by rolling funds to another account.

Variations of these methods may also satisfy the substantially equal payment exception (however, the account owner should obtain a private letter ruling before using an alternative method). For example, in various letter rulings, the IRS has allowed annual cost-of-living adjustments (COLAs). It has also allowed a taxpayer using the amortization method to redetermine his periodic payments annually based on his account balance at the time of redetermination (Letter Ruling 200105066). This method allows the taxpayer to begin fresh every year. If an account is performing well, the account owner may take larger periodic payments. Likewise, if there is a decrease in an account balance, he or she can keep more assets within the IRA.

Example 3: S’s IRA balance on December 31, 2009, was $800,000. Her daughter, D, is the beneficiary of the IRA. S is 50; D is 30. S wants to begin taking distributions from her IRA in 2010 and plans to avoid the early withdrawal penalty by using the substantially equal payment exception. Using the MRD method to calculate the payment, her distribution in 2010 is $23,392, based on her age and the single life expectancy table of Regs. Sec. 1.401(a)(9)-9.

Under the MRD method, the amount of payment is determined annually based on the account balance and the owner’s age for that year. Thus, if S’s IRA balance at the end of 2010 (after the $23,392 distribution) is $810,000, her distribution for 2011 would be $24,324 ($810,000 ÷ 33.3).

Example 4: Assume instead that S uses the amortization method to calculate the amount she can take from her IRA each year without incurring the early distribution tax. Further, assume that the highest possible interest rate S can use (i.e., 120% of the highest federal midterm rate for the two months before the SEPPs commence) is 4.5%.

Using a 4.5% interest rate and the 34.2 life expectancy from the single life table, S’s payment will be $46,269. This is the largest possible SEPP S can take. If she wants a smaller payment, she can use a lower interest rate or transfer funds to another IRA not subject to the substantially equal payments. However, she cannot use a higher rate.

Using the fixed amortization method, the distribution amount is not recalculated in subsequent years as it would be using the MRD method. Thus, S will withdraw $46,269 each year.

S can switch to the MRD method at the beginning of any future year. However, once S makes the switch, she must use the MRD method for the balance of the required payment period. In addition, if instituted when payments are originally set up, it may be possible for S to instead redetermine the payment annually using the account balance at the end of the prior year (see Letter Ruling 200105066).

The substantially equal payment exception does not require an individual to aggregate all of his or her IRAs when calculating the annual distribution amount. Thus, individuals with more than one IRA can calculate payments from one account without considering the balance held in other IRAs. In addition, individuals are not required to make similar periodic payments from the other IRAs (Letter Ruling 8946045). However, the entire balance in any one IRA must be considered. Amortizing only a portion of an IRA over the applicable life expectancy does not qualify for this exception (Letter Ruling 9705033).

The substantially equal payment (however calculated) is the exact payment that the account owner must make under this exception. Any distribution in excess of this amount is a premature distribution subject to the early distribution tax. However, the IRS may allow (subject to a private letter ruling) the account owner to adjust payments annually for COLAs (Letter Ruling 9536031). The account owner must request the IRS’s permission to use a COLA when payments are originally set up. Adding a COLA after payments have begun will result in the payments being subject to the 10% penalty tax (Letter Ruling 199943050).

Caution: Once annuity-like withdrawals have begun, the owner should be careful not to make any additional contributions, nontaxable transfers, or rollovers into that account. Doing so will be treated as a change in the payment, resulting in retroactive application of the premature distribution tax.

Conclusion

Individuals are allowed a great deal of flexibility in meeting the substantially equal payment exception. By varying the method, life expectancy table, and interest rate used to calculate the distribution and the amount in the IRA subject to the payments, the amount of distribution can be tailored to meet the individual’s needs. The following general principles may be considered in structuring substantially equal payments:

• Payments will be comparatively lower (and last longer) if calculated under the MRD method than under the other two methods. Also, there is no danger of withdrawing all the account assets during the owner’s lifetime under the MRD method because life expectancy is recalculated annually.
• For any retirement account (or combination of retirement accounts), the amount calculated using the amortization method, 120% of the highest federal midterm rate for the previous two months, and the single life table will result in the largest possible payment from the account(s). A smaller payment can be calculated by using a lower (down to 0%) interest rate, using the joint life expectancy or uniform life table, and/or transferring funds to another retirement account not subject to the payment.
• There is little reason to consider the annuity factor method because it will always result in a payment that is slightly less than that calculated under the amortization method using the same interest rate.
• Where possible, it is best to split retirement funds into at least two accounts before payments begin. One account can then be used for the current substantially equal payment while the other is held in reserve. If larger payments are needed before the end of the five-year/age 59½ period, a new substantially equal payment can be started from the reserve account. Thus, distributions can be increased without disturbing the payments from the original account.
• Payments can be increased or decreased by altering the amounts in the taxpayer’s various accounts before the distributions begin, as only the amount in the retirement account from which the distribution will be made needs to be considered in the payment calculations. (However, the entire account balance must be used to calculate the distribution amount.)
• It may be possible to adjust the payment for cost-of-living increases and still qualify for the exception, as long as this method is adopted when the payment is first set up.
• However the payment is calculated, it is important to keep documentation in the client’s file that clearly indicates (1) the method, interest rate, and life expectancy table used in the calculation; (2) the payment amount and how it was calculated; and (3) any special computations, such as a COLA. It is also a good idea to keep a log of the payments as they are taken (including copies of the Forms 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) and a copy of the applicable account statements for the five-year/age 59½ period (to show that no deposits or other distributions were made from the account).

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 11th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft. Worth, TX, 2009 ((800) 323-8724; ppc.thomson.com).

EditorNotes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.