Changes to Account Balance by William J. Stecker With these concepts in mind, lets take a more detailed look at each of the three “modifications” identified by the IRS:
Usually, IRS regulations & rulings are lengthy (in both time to issue as well as pages), technically precise and confusing in the sense that one can get lost in the trees and not see the forest. Revenue Ruling 2002-62 is the exception to the general rule. From inception to issuance only took 4 - 6 months (read Warp 10), is a model of brevity, but also contains some extremely confusing language.
For the first time, Revenue Ruling 2002-62 provides some guidance on deferred account management and what the Service will consider to be a modification remembering that a "modification" invokes IRC §72(t)(4) which in turn imposes the 10% surtax plus interest from the commencement of the substantially equal periodic payment stream. Thus, all taxpayers are desirous of avoiding the following:
(e) Changes to account balance. Under all three methods, substantially equal periodic payments are calculated with respect to an account balance as of the first valuation date selected in paragraph (d) above. Thus, a modification to the series of payments will occur if, after such date, there is (i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable. Revenue Ruling 2002-62.02(e)
At first glance, the above seems to be pretty clear. Upon second glance it gets confusing. Upon third glance, it becomes downright contradictory. Upon fourth glance, no one is absolutely sure what it says. Further, there have been no subsequent rulings or other explanations to provide additional guidance on what this really means. As a result, we are in new territory and have to make some educated guesses as to the Service’s intent. However, there are two or three principles that can guide us in the following analysis:
(1) IRC §408(d)(3)(A) is commonly called the "rollover" rule. It statutorily grants every taxpayer the ability to distribute money from an IRA to themselves (thus initially creating a taxable event) and then subsequently redepositing those monies into an IRA within 60 days (thus erasing the taxable event). Further, taxpayers can elect to perform one rollover per year per account. Thus, using the rollover rule, a taxpayer might withdraw $20,000 from their IRA to payoff a car loan; sell the car within 60 days and use the sale proceeds to put the $20,000 back in the IRA.
(2) Related to (1) above but technically dissimilar are "trustee-to-trustee" transfers ("TTTT"). TTTT’s are not qualified under IRC §408(d)(3)(A) because technically they are not rollovers; instead they are, from inception, tax exempt transfers from trustee A to trustee B without intervention by the taxpayer. In this case, the taxpayer never has constructive receipt of the money (unlike (1) above) but would use this technique to move an IRA from an old full-service brokerage to a new discount brokerage. See Revenue Ruling 78-406 (1978-2 CB 157).
(3) The IRS has explicitly identified three circumstances which they consider to be "modifications". However, some of the language in Revenue Ruling 2002-62 seems to run in conflict with (1) and (2) above; or does it? This author would suggest a little creative language expansion to clarify the situation. When ruling reads: "a modification to the series of payments will occur if," should be interpreted to read as: "a modification to the series of payments will occur if the taxability of the payments is altered as a result of:".
(i) any addition to the account balance other than gains or losses,
During the Summer & early Fall of 2002, the Assistant General Counsel’s office was inundated with private letter ruling requests all implicitly suggesting mechanisms for individual taxpayers to either terminate or materially modify their SEPP distributions. One of the tactics frequently suggested was the use of “account replenishment”. Assume John commenced SEPPs some years previous with an opening IRA balance of $1,000,000. However, John, split his IRA into two IRAs, A & B with $700,000 and $300,000 respectively. He commenced his SEPP distributions on IRA A only. Several years later, IRA A had materially diminished in value, let’s assume to $200,000, thus presenting a circumstance where John faced certain account exhaustion before his 59 ½ birthday. John, through a PLR request suggested a corrective action by “replenishing” IRA A with the contents of IRA B; implicitly recasting the SEPP program from inception with a starting balance of $1,000,000. This strategy would have solved John’s problem of insufficient assets; however, it clearly would have applied to only those taxpayers who had bifurcated their IRA assets before commencing SEPP distributions. Effectively, this portion of the ruling disallows this strategy with a direct NO. Further, permissibility of such a transaction would likely change the timing and/or amount of distribution taxability. Lastly, other portions of Revenue Ruling 2002-62 give taxpayers several other “outs” to either decrease or terminate their distributions thus making this technique rather moot.
TRANSFERS TO RETIREMENT PLANS
(ii) any nontaxable transfer of a portion of the account balance to another retirement plan,
Let’s remember that for purposes of IRC §72(t), we need to look at IRC §4974(c) for a definition of a “retirement plan”. In this case we find all the usual suspects: §401(a) plans; §403(b) plans and §401(k) plans. In addition, §408(a)’s are included; more commonly known as IRAs. Therefore a literal read of the above says an IRA-to-IRA rollover or a TTTT is no longer permitted! Not true. Congress has traditionally taken a pretty dim view whenever the IRS has attempted to overrule them as would seem to be the case here. However, the IRS is not attempting to overrule Congress; if anything, the IRS is simply guilty of some sloppy language. What the IRS was trying to say was a taxpayer can not use a rollover or TTTT to alter the taxability of the substantially equal periodic payment stream.
As an example, some taxpayers originally commenced SEPP distributions from a conduit IRA created from a prior employer qualified plan distribution. Seeing their assets evaporate, some of these taxpayers re-entered the work force and were re-employed by employer who also had a qualified plan that accepted rollovers. Some taxpayers wanted to “roll-in” the contents of their conduit IRA into their new employer’s plan. Needless-to-say, the SEPP distributions would have to stop as the new employer could not continue the periodic distributions as it would represent a violation of the “separation of service” rule. In short, it was an ill-fated strategy of using a new retirement plan as a blocking mechanism to cease SEPP distributions prematurely. Again the Service has sensibly said NO; they just did not say it very well.
(iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.
Well of course, the purpose of doing a rollover is so that it is not taxable. In this case, however, the IRS is talking about attempted rollovers of the distribution dollars as opposed to rolling over all or portion of the corpus of an IRA. Rollovers of required minimum distributions have long been disallowed pursuant to IRC §401(a)(9) & related regulations; otherwise everyone’s grandmother would make their RMDs and then immediately roll them over into an IRA thus perpetuating an IRA account forever. The same applies here.
One of the other asset preservation strategies suggested was for John to run the SEPP distribution dollars in a circle. John was taking one annual distribution of $60,000 per year from his original IRA of $700,000; now down to $200,000. Further, John realized the impractability of his situation and re-entered the employed workforce; thus, John no longer wanted or needed the $60,000 per year distribution. John though why not just rollover the $60,000 distribution into the same or other IRA thus erasing the taxable event and preserving his IRA assets. Again, the Service has said NO.
The key to interpretation of all three situations is an examination of how the taxability of the SEPP distributions is altered (not good) or remains unaltered (generally okay). The transactions in each case are permissible, as granted by statute or earlier proclamation by the IRS. No one was attempting to take away any taxpayer rights here; simply the IRS was putting everyone on notice to not attempt to alter the taxability of the SEPP distribution stream through inappropriate use of any of these techniques.
Changes to Account Balance
by William J. Stecker
With these concepts in mind, lets take a more detailed look at each of the three “modifications” identified by the IRS: