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72(t) Frequently Asked Questions [FAQ]
Q. How is my age calculated?
A. Your age would be your attained age as of your birthday in the
calendar year in which the distributions commence. PLR 8946045
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Q. What documentation should be maintained for a SEPP plan?
A. The safe course of action is to document the plan and all plan
transactions.
The starting point would be to reduce the terms of the plan to a written
document that outlines all the details including the payment calculation method
to be used, when payments are to commence and the frequency of the payments.
There is a sample form on our side that can be used a guide.
I would also keep copies of the account statements that were used to determine
the initial payment and if any recalculation method is used, the statements for
each recalculation. In addition I would also keep copies on the statements
reflecting the transactions as they occur.
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Q. Are there any IRS filing requirements?
A. That depends on how form 1099-R is coded when you receive it from
the Trustee/Custodian that is making the SEPP distributions. If 1099-R box 7 is
coded with a 2 (early distribution, exception applies under age 591/2) then
nothing additional needs to be filed. If however, box 7 has a code of 1 (Early
distribution, no known exception) or 7 (normal distribution) then you must file
IRS Form 5329 to claim the exemption to the 10% penalty tax.
Plan early. When you have designed the plan, communicate with the
Trustee/Custodian that will be making the distributions and see if they will be
using a code of 2 on the 1099-R. If not, prepare to file form 5329 or perhaps a
new funding vehicle for the plan.
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Q. What account balance should be used?
A. Rev. Ruling 2002-62, 2.02(d) states... "The account balance
that is used to determine payments must be determined in a reasonable manner
based on the facts and circumstances. For example, for an IRA with daily
valuations that made its first distribution on July 15, 2003, it would be
reasonable to determine the yearly account balance when using the required
minimum distribution method based on the value of the IRA from December 31,
2002 to July 15, 2003. For subsequent years, under the required minimum
distribution method, it would be reasonable to use the value either on the
December 31 of the prior year or on a date within a reasonable period before
that year's distribution."
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Q. Do All IRA Accounts have to be combined to determine the amount of the
distribution?
A. Individual retirement plans do not have to aggregated for purposes of calculating these payments. If a taxpayer owns more than one IRA, any
combination of the taxpayer’s IRAs may be taken into account in determining the distributions by aggregating the account balances of those IRAs. PLR 9050030. Also review PLR 9525062. It also deals with using multiple accounts to fund a single SEPP.
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Q. Can a portion of an IRA account be excluded from the calculations?
A. No, the entire account balance in each of the pertinent IRA's must
be taken into account. A portion of one or more of the IRAs may not be excluded
in order to limit the periodic payment to a predetermined amount. PLR 9705033
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Q. If I include more than one account, which accounts do I use to make the payments?
A. If two or more IRA's are used in determining the substantially equal
periodic payments, the distributions need not be made from all of the included
IRA accounts. The distributions may be made solely from one of the accounts, or
from a combination of the accounts. PLR 9705033
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Q. I have a SEPP and have been re-employed and have earned income. Can I make a
contribution to an IRA?
A. All accounts are treated individually. Do not touch the SEPP
account, but rather establish a new IRA account and make the contributions to
it.
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Q. I have a SEPP that used one of my two IRA accounts, can I set up a second SEPP with the other account?
A. Since all accounts are treated individually, there is no reason that
the second IRA couldn't be used to establish a second plan, totally independent
of the first plan. Just make sure that the appropriate payment comes from the
appropriate plan.
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Q. Can a Cost of Living Adjustment (COLA) be included?
A. Under Rev. Rul. 2002-62 COLA Increases are not allowed for
plans adopted after 12/31/2002. Prior to 01/01/2003, there were at least 2 PLRs
that allowed COLA increases<
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PLR 9503631 - This annual distribution amount will be increased by a 3 percent
cost-of-living factor for each year after 1994. Thus, the annual distribution
amount for 1995 will equal 103 percent of the 1994 distribution amount, and for
years subsequent to 1995 the annual distribution amount will equal 103 percent
of the prior year annual distribution amount.
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PLR 199943050 - Absent appropriate language permitting annual cost of living
adjustments at the time of the initial substantially equal periodic payment,
the recalculation of the annual distribution amount to include a 4% cost of
living adjustment, and a one-time catch-up payment, would be a modification of
the distributions that would trigger the premature distribution penalty.
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Q. Can distributions be made monthly?
A. While payments must be made at least annually, several letter
rulings address the subject of monthly payments.
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PLR 8919072
- The annual distribution amount was distributed as 12 equal monthly payments.
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PLR 9050030
- The distributions were calculated as monthly distributions using a monthly
compounding rate. In this ruling the remaining life expectancy was was
converted to months by converting the fractional life expectancy to the nearest
whole month.
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PLR 200105066 - The annual distribution was divided by 12 with
the first payment to be made in July - only six payments were made in year 1
with the second annual payment calculated in January of the following year.
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Q. Which Mortality Tables can be used?
A. SEPP plans adopted after 12/31/2002 must use the Annuity
2003 table published by the IRS and used in both the final Minimum Distribution
regulations and Rev. Rul. 2002-62.
Plans adopted prior to 01/01/2003 had much more flexibility. Notice 89-25 used
the term "reasonable mortality table" in outlining the third alternative
used in the description of substantially equal payments. In its calculations,
the IRS used the UP-1984 table. The 1983(a) tables is used to determine life
expectancies in methods number one and number two so it should also be usable
in method number three. Recently the IRS replaced the 80CSMT table with the
90CM table which should also be considered reasonable. Under 20002-62, only the
Annuity 2003 Table may be used.
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Q. Once started, how long must I continue the plan?
A. Once started, these payments must continue for the longer of five
payment years (from the date of the first distribution) or until age
59-1/2. So, if you retire at age 52, you would have to continue the payments
until at least age 59-1/2 before you could change them. If you did this, you
would pay ordinary income tax on the distributions, but no 10 percent penalty.
If you are age 55 to age 59 when payments begin, you must continue for
the full five years even though you have reached age 59.5 in less than 5 years.
Once you've met the five-year or age 59-1/2 point, you can change the
distribution pattern, even stopping distributions altogether until you reach
70-1/2 when the Minimum Distribution Rules apply.
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Q. What if I run out of money?
A. Note, 2002-62 allows plans that run out of funds to NOT incurr
the 10% penalty tax. Rev. Ruling 2002-62, 2.03(a) states... "If, as a result of
following an acceptable method of determining substantially equal periodic
payments, an individual's assets in an individual account plan or an IRA are
exhausted, the individual will not be subject to additional income tax under
72(t)(1) as a result of not receiving substantially equal periodic payments and
the resulting cessation of payments will not be treated as a modification of
the series of payments."<
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Q. If I get divorced and transfer a portion of the payments to my ex-spouse, will
I loose the exemption from the 10% penalty tax?
A. The transfer to a taxpayer’s spouse pursuant to a divorce decree of
50% of each of three separate IRAs owned by the taxpayer from which the
taxpayer had already begun receiving “substantially equal periodic payments”
did not result in a modification where the taxpayer’s spouse was two years
younger and would commence receiving similar payments such that the total of
periodic payments to the taxpayer and his spouse subsequent to the division
would be substantially equal to the periodic payments received by the taxpayer
prior to the division. PLR 9739044
In PLR 200027060, the IRS rules that a spouse after the divorce, that
received a portion of the client's IRA accounts that were being used to fund a
SEPP, didn't need to continue the payments since it was a transfer under
Code section 408(d)(6). What about the client - did all the payments have to be
continued out of what remained of his accounts?
Later in PLR 200050046 (with similar facts) the IRS ruled in favor of the
taxpayer. "The reduction in the annual distribution from IRA 1 to Taxpayer A
beginning in calendar year 2001, prior to Taxpayer A's attaining age 59 1/2 ,
and assuming Taxpayer A has not died and has not become permanently disabled,
will not constitute a subsequent modification in his series of periodic
payments, as the term "subsequent modification" is used in Code section
72(t)(4), and will not result in the imposition upon Taxpayer A of the 10
percent additional income tax imposed by Code section 72(t)(1) pursuant to Code
section 72(t)(4)(A)(ii).
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Q. Once started, can I change the payment?
A. Rev. Ruling 2002-62, 2.03(b) allows a one time change to the
Minimum Distribution method if the current plan was based on either the
Amortization or Annuitization methods. Other than the change
above, once you begin withdrawing assets using SEPP, you may face
retroactive penalties and interest if you change the conditions for taking
payments.
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Q. Can I recalculate my Life Expectancy using the Amortization or Annuity Methods?
A. Since Rev.Rul. 2002-62 was initially released, there have been
(as of 05/13/05) three PLRs that have allowed for recalculation option. See the
PLRs of Interest page.
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Q. What if I die or become disabled?
A. If you die after you begin receiving payments, the proceeds of your
retirement plan will be exempt from the 10% penalty tax and retroactive
interest . Your beneficiary will receive your retirement assets penalty-free
and will not be required to continue with the plan. In addition , if you become
permanently disabled before you satisfy plan requirements, the penalty tax and
the retroactive interest provision do not apply.
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Q. How are my non-deductible contributions treated?
A. If you have made non-deductible contributions, a portion of each
payment will be received income tax-free as a return of contributions. All
interest earned, even interest earned on non-deductible contributions will be
subject to tax.
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Q. What is a Private Letter Ruling?
A. If you feel that your circumstances warrant prior approval from the
IRS - for example, you plan to calculate your payments and use a cost of living
index - you may want to obtain a private letter ruling from the IRS before you
take a distribution.
A private letter ruling is an IRS response to a taxpayer’s formal request for
an opinion on the taxpayer’s situation. The IRS charges a fee for each such
ruling. Although many tax experts rely on these rulings to broadly interpret
the position of the IRS on various issues, each ruling applies only to the
taxpayer actually requesting it .
For 2002, the procedure on obtaining a private letter ruling from the IRS, you
can consult Revenue Procedure 2002-1 (pages 125+), for the steps to follow and
pages 56+ and Appendix A for User Fees. The procedure is usually contained in
the first Internal Revenue Bulletin issued each year.
Remember, if you want to be 100% sure you'll survive an IRS audit on your SEPP,
get your own private letter ruling. A professional tax or financial adviser can
also help you obtain a private letter ruling.
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Q. What is the Definition of Disability for
72(t)??
A. The definition of disability can be found in IRC Section 72(m)(7).
In one case,Dwyer v. Comm., 106 TC No. 18 (1996), the Tax Court agreed
with the IRS and stated...
For purposes of this rule, an individual is considered disabled if "he is
unable to engage in any substantial gainful activity by reason of any medically
determinable physical or mental impairment which can be expected to result in
death or to be of long-continued and infinite duration." The Code specifies
that an individual must be able to furnish proof of his disability in whatever
form and manner that the Service may require. The court noted that the
regulations under Section 72 also state that an impairment that is remediable
does not constitute a disability.
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Q. Can I vary the plan payments by my account balance?
A. 2002-62 Only allows recalculation of the account balance under
the Minimum Distribution method.
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Q. Assuming the 5-Year rule, when can payments be modified?
A. In 1998, a tax court held that a payment received by a
taxpayer after he received five equal annual installments and after he reached
age 59-1/2 was a modification of the Substantially Equal Periodic Payments.
The Court held that the modification occurred within the 5-year period
beginning with the first payment, thus triggering the recapture of the
10-percent penalty tax. The Service argued that the 5-year period began with
the first distribution and ran until the end of the 5th year. The tax court
agreed - the 5-year period closes at the end of the 5 years beginning with the
first distribution, and does not end on the date of the 5th annual
distribution.
Arnold v. Comm., 111 TC No. 12 (1998).
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Q. Are your Calculators Accurate?
A. Yes, but don’t just take our word for it. IRS Notice 89-25
describes three methods in which payments will be considered to be
substantially equal periodic payments:
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The life expectancy method - calculated under the minimum distribution rules.
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The amortization method - amortize account balance using life expectancies and
a reasonable interest rate.
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The annuitization method - account balance divided by an annuity factor using
both a reasonable mortality table and interest rate.
Don't just accept the results of any calculator - check them out to see if
they match the results that the IRS produced.
From 89-25: Male Age 50, 8% Interest & UP1984 Mortality.
- Life Expectancy: 33.1 years
- Amortized Payment: $8,679
- Annuity Payment: $9,002
From 2002-62 FAQ: Male Age 50, 4.5% Interest, $400,000
IRA.
- Life Expectancy: 34.2 years
- Minimum Distribution: $11,695.91
- Amortized Payment: $23,134.27
- Annuity Payment: $22906.68
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Q. What about IRC Section 72(q) for Non-Qualified Tax-Deferred Annuities?
A. On March 1, 2004 in Internal Revenue Bulletin:
2004-9, Notice 2004-15. The IRS appears to have extended Revenue Ruling 2002-62
to non-qualified annuities. If correct, the flexibility of 89-25 and the
various PLRs leading up to Revenue Ruling 2002-62 are now gone - for all plans.
For additional details, see the Discussion Post 'IRS Helps Again'.
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Q. I have been searching for a definition of what exactly is the "federal
mid-term rate" Can you tell me where this interest rate comes from?
A. Each month the IRS posts a table of Applicable Federal Rates
for the nest month. Whie the actual for calculating these rates seems to be
known only to the IRS, you can get a general feeling of where the mid-term
rates are going by watch the 5-Year Treasury Note.
IRS AFR Page
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Q. What is the impact of Internal Revenue Bulletin: 2004-9, Notice 2004-15 on Non-Qualified Tax-Deferred Annuities?
A. On March 1, 2004 in Internal Revenue Bulletin: 2004-9, Notice
2004-15. The IRS appears to have extended Revenue Ruling 2002-62 to
non-qualified annuities. If correct, the flexibility of 89-25 and the various
PLRs leading up to Revenue Ruling 2002-62 are now gone - for all plans.
The following segments were extracted from the Notice...
"The IRS and Treasury believe that because these provisions were enacted for
the same purpose it is appropriate to apply the same methods to determine
whether a distribution is part of a series of substantially equal periodic
payments. Therefore, taxpayers may use one of the methods set forth in Notice
89-25, as modified by Rev. Rul. 2002-62, to determine whether a distribution
from a non-qualified annuity contract is part of a series of substantially
equal periodic payments under § 72(q)(2)(D).
First, an individual is not subject to the § 72(t)(1) additional tax if (i) the
payments are not substantially equal because the assets in the individuals
account plan or IRA are exhausted, and (ii) the individual followed one of the
prescribed methods of determining whether payments are substantially equal
periodic payments. See Rev. Rul. 2002-62 § 2.03(a).
Second, an individual who begins receiving distributions in a year using either
the fixed amortization or fixed annuitization method may switch to the minimum
distribution method for the year of the switch, and all subsequent years, and
the change will not be treated as a modification within the meaning of §
72(t)(4). Any subsequent change, however, will be a modification for purposes
of § 72(t)(4). See Rev. Rul. 2002-62 § 2.03(b).
The IRS and Treasury believe that, when the provisions of § 72 are intended to
address different concerns with respect to the treatment of qualified and
non-qualified annuities, it is appropriate to apply those provisions in a
different manner. However, if the provisions of § 72 are designed to achieve
the same purpose whether or not the annuity is qualified or non-qualified, it
is appropriate to apply that provision in the same manner to both qualified and
non-qualified annuities."
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Q. Does anyone know of any actual cases where someone accidentally broke their 72t and were caught by the IRS? What were the actual penalty percentages? Do they ever give someone a break and let them fix it if possible? Do they ever waive the penalties and interest? If someone was taking 72t withdrawals for 7 years and then switched to the MD method and calculated wrong and withdrew $100 too much would the IRS actually charge $100,000 if that was what the interest and penalties would come to?
A. When all the dust settles, the IRS must impose IRC §72(t)(1)&(4) --- essentially the code sections that impose the 10% surtax plus interest; e.g. the IRC can not "give some one a break". Therefore, determining that a SEPP plan is busted can itself be difficult to determine; however, financial records have a tendency to speak for themselves.
Therefore, when the determiniation is made that a SEPP plan was/is busted, the IRS always imposes the 10% surtax plus interest without exception. These penlaties & interest are never waived and the amounts are not negotiable or subject to compromise.
If the taxpayer discloses on their return that their SEPP plan is busted then it is a straight math exercise of computing the penalties and interest. The interest rates have recently ranged from a high of 8% to as low as 4% depending the periods of time involved.
If the taxpayer does not disclose that their SEPP plan is busted and the issue is uncovered during an audit, then all of the above applies plus "substantial underpayment penalties" and "fraudulent return penalties" which can add an additional 20% to 50% on top.
All of these amounts are tallied up in a deficiency notice from the IRS. If, after 90 days, the taxpayer can not or refuses to pay these amounts the IRS commences "levy & attachment" proceedings; e.g. they come at you are start taking your other assets. In short, the IRS does not offer any lienency in this process because the law does not permit it.
The above is why SEPP plans can be considered dangerous. They are executory for years; as few as 5 and as long as 15 or so. Inadvertent errors can occur & it is the taxpayer's responsibility to be continually checking to make sure that everything is done exactly as it should be. Unfortunately, when an error does occur, the financial advisors, brokers, custodians and trustees all have a tendency to run for cover leaving the taxpayer more or less standing naked in front of the IRS.
Posted to the Discussion area on 12/16/2005 by the Badger in response to a Question from Mike.
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