TIRED OF WAITING FOR 59 wQ ? YOU MAY WANT TO TRY 55
By Cecyl D. Stott
It is well known that at age 59 wQ or older the rules with respect to qualified retirement plans and other retirement vehicles (e.g., IRAs) permit the withdrawal of funds without penalty, but that such withdrawals are considered ordinary income subject to a tax based at marginal tax rates. The allure of retirement is so keen that some people seem to be counting the days until they reach the magic 59 wQ so that they can begin drawing from the tax sheltered plans they have been paying into for most of their working lives. Retiring earlier than that seems to be almost within their grasp due to the significant increase in their investments during the past four or five years from the doubling of securities values in the marketplace.
The 59 wQ benchmark is spelled out in IRC section 72(t)(2)(A)(i). Withdrawals prior to that age are generally subject to a premature withdrawal penalty, generally a flat 10% of the gross amount withdrawn, in addition to any income taxes that may be payable because of the inclusion of the withdrawal in taxable income. For example, if a person's marginal tax rate were 31%, he or she would end up paying a composite 41% on the total withdrawal.
However, there is a bright spot in the code. If, during or after the calendar year in which an individual reaches age 55, the individual is or was a participant in a qualified employer plan and meets specific qualifications, the early withdrawal penalty may be circumvented. Please note that the following discussion applies only to qualified employer plans and not to IRAs.
Qualified Employer Plans
IRC section 72 notes that the term "qualified employer plan" shall include any plan that is (or is determined to be) a qualified employer plan or government plan. A government plan means any plan, whether qualified or not, established and maintained for its employees by the United States, a state or political subdivision thereof, or by an agency or instrumentality of any of the foregoing.
The term qualified employer plan includes the following:
* A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of its employees or their beneficiaries
* An annuity contract purchased by an employer for an employee under a plan that meets the requirements of section 404(a)
* An annuity purchased by a section 501c(3) organization for an employee who performs services for a section 170(b) educational organization, by an employer that is a state, a political subdivision thereof, or an agency or instrumentality of any one or more of the foregoing.
If an individual can satisfy the qualified employer plan test, then he or she should turn attention to the IRS's Publication 575. The section "Tax on Early Distributions and Exceptions to Tax" reads as follows: "The 10% early distribution tax does not apply to distributions that are made to you after you separated from service with your employer if the separation occurred during or after the calendar year in which you reached age 55." This section goes on to note that this provision applies only to distributions from qualified employer plans.
The amount an individual can withdraw has prescribed qualifications as noted in IRC section 72(t)(2)(A)(iv). It states that the 10% penalty for premature distributions from an annuity contract shall not apply to any distribution that is a part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and a designated beneficiary.
For example, the ordinary life multiple for a one-life expected return is 28.6 years at age 55. Assume an individual at age 55 has a beginning value of $250,000 (and an assumed six percent earning rate) in a qualified plan and is going to start withdrawals. The maximum distribution using age 55 with no survivor clause would amount to approximately $18,300 per year.
A joint-life annuity approach generally will provide a lesser amount per year. Assume that a taxpayer is 55 years of age at the inception of the plan withdrawals and either is married or the plan includes a survivor clause. If married, assume the spouse is 50 years of age and the taxpayer wants to utilize a last survivor annuity or simply a two-lives expected return multiple. The government life expectancy table has a multiple of 37.1 years based on the above ages. Under this scenario, the maximum amount that could be drawn out would be approximately $16,820 per year.
In the discussion regarding changes in the substantially equal periodic payments, reference is made to IRC section 72, the section dealing with a qualified employer plan. Section 72(t)(4) states that a substantially equal payments criterion will be deemed to be met if the series of payments are subsequently modified other than by reason of death or disability--
1) before the close of the five-year period beginning on the date of the first payment and after the taxpayer attains age 59 wQ , or
2) before the taxpayer attains age 59 wQ . This should be done with caution, however, to allow for modification subsequent to establishing the life expectancy withdrawals.
Also, section 72(t)(4)(A) imposes an additional tax plus interest to compensate for any tax deferral.
It appears that if an individual who is 55 years of age or will be in his or her starting year starts withdrawing from the sheltered monies, he or she will be required to use the life expectancy for determining the withdrawal amount to preclude triggering the 10% penalty tax. Then, upon reaching age 59 wQ (and before five years have lapsed from the date of the first early payment or before reaching age 59 wQ ) he or she will be able to withdraw any amount of the sheltered money annually (which would not necessarily be based on their life expectancy subject to an additional tax and interest). It also appears that if one does not change from equal payments based on his or her life expectancy within this five-year window then his or her payments will have to remain at the amount determined by his or her life expectancy. *
Cecyl D. Stott, CPA, is an assistant professor of accounting at Southwest Texas State University.
Editor's note: Two recent court cases in this month's News & Views illustrate what happens when the IRC sections are not strictly followed.
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
Richard M. Barth, CPA
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