By Joseph W. Bencivenga, CPA, O’Connor Davies & Company LLP

With the stock market posting impressive returns in the 1990s, many individuals find their retirement plans flush with high-flying investments and contemplate early retirement. However, there is one formidable obstacle: the 10% penalty for early withdrawals from retirement plans.

Is there a way to circumvent this penalty? Yes. A little-known exception for withdrawals that constitute “substantially equal periodic payments” may be just what the accountant ordered for early retirees.

Avoiding the Early Withdrawal Penalty

IRC section 72(t)(2)(A)(iv) provides an exception for distributions that are part of a series of substantially equal periodic payments (not less frequent than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of employee and beneficiary. This interesting exception can be the key to early retirement.

Neither the IRC nor the Treasury Regulations define “substantially equal periodic payments.” To assist those grappling with this term, the IRS has issued Notice 89-25. Question 12 of the notice provides three methods for determining substantially equal periodic payments:

Minimum Distribution Method

The minimum distribution method permits the calculation of payments to be made using a method that would be acceptable for the purposes of calculating the minimum distribution required under IRC section 401(a)(9). The payment may be based on the life expectancy of the employee or the joint life and last survivor expectancy of the employee and the named beneficiary.

An example of the minimum distribution method calculation follows: Assume a 50-year-old taxpayer with an IRA account balance of $2 million in 2000. Using the single life expectancy table (Table I) from Publication 590, this taxpayer is expected to live for 33.1 years; $2 million divided by 33.1 years equals $60,423. Therefore, the taxpayer must distribute $60,423 from her IRA account for 2000. Because the single life expectancy factor changes as a taxpayer gets older, the minimum distribution amount must be recalculated each year.

Amortization of Account Balance

The amortization of account balance method amortizes the taxpayer’s account balance over a number of years equal to the life expectancy of the account owner or the joint life and last survivor expectancy of the account owner and beneficiary at an interest rate that does not exceed a reasonable interest rate on the date payments commence.

Assume a 50-year-old individual with a life expectancy of 33.1 years, an account balance of $2 million, and an assumed interest rate of 8%. Amortizing the $2 million account balance over 33.1 years at 8% comes to $173,580 annually. Distributing $173,580 annually would therefore satisfy the substantially equal periodic payment provision.

Annuity Factor

The third method allows payments to be treated as substantially equal periodic payments if the amount to be distributed annually is determined by dividing the taxpayer’s account balance by an annuity factor (the present value of an annuity of $1 per year beginning at the taxpayer’s age attained in the first distribution year and continuing for the life of the taxpayer). The annuity factor is derived using a standard mortality table and a reasonable interest rate.

Given an annuity factor of 11.109 for a $1 per year annuity for a 50-year-old individual (calculated using an interest rate of 8% and the UP-1984 Mortality Table), a $2 million account balance would yield annual distribution of $180,035 ($2 million divided by 11.109).

Section 72(t)(4)(A) Pitfalls

IRC section 72(t)(4)(A) must be followed carefully to avoid drastic penalties that would nullify the advantages to this early retirement strategy. Section 72(t)(4)(A) states that if the series of payments is subsequently modified (other than by reason of death or disability) before the end of a five-year period beginning with the date of the first payment and after the employee attains age 59 1/2, then the taxpayer is subject to the 10% penalty. The penalty will also apply if the five-year period has elapsed and the series of payments is modified before the employee attains age 59 1/2.

Section 72(t)(4)(A) describes the penalty resulting from a subsequent modification as follows: The taxpayer’s tax for the first taxable year in which such modification occurs is increased by an amount equal to the tax which would have been imposed, plus interest for the deferral period. Section 72(t)(4)(B) defines the deferral period to be the period beginning with the taxable year in which the distribution would have been includable in gross income and ending with the taxable year in which the modification occurs.

Example 1. Assume a taxpayer, upon turning 54 on January 1, 1996, commenced annual withdrawals of $50,000 from an IRA that constituted a series of substantially equal periodic payments. He withdrew $50,000 on January 1, 1996, 1997, and 1998. On January 1, 1999, he withdrew $60,000, impermissibly modifying the stream of payments.

Because he subsequently modified his payments before the close of the five-year period beginning with the date of the first payment, he would be subject to a penalty totaling $21,000, plus interest, calculated as follows:

Example 2. Assume the same facts in the first example, except the taxpayer turns 58 on January 1, 1996. Her penalty would be $10,000, plus interest, calculated as follows:

There would be no penalty thereafter, because by January 1, 1998, the date of her next withdrawal, the penalty applies only to those withdrawals made before the taxpayer reaches the age of 59 1/2. The penalty still applies for the withdrawals in 1996 and 1997 because the series of payments was modified before the end of the five-year period beginning with the date of the first payment.

Example 3. Assume a taxpayer, upon turning 51 on January 1, 1993, commenced annual withdrawals of $50,000 from an IRA that constituted a series of substantially equal periodic payments. She withdrew $50,000 each January 1 until January 1, 1999, when she impermissibly modified the stream of payments by withdrawing $60,000.

The taxpayer would be subject to the penalty because the series of payments was modified after the close of the five-year period but before she attained age 59 1/2. The penalty would be $36,000, plus interest, calculated as follows:

Further Clarification Needed

The statute and regulations do not define the term “subsequent modification.” As a result, taxpayers have no authoritative source to evaluate a proposed modification and must turn to precedent or private letter rulings.

In private letter rulings, the Tax Court and the IRS appear to allow modifications that do not depart from the spirit of Notice 89-25. Modifications unforeseen at the time payments commenced, such as those resulting from a reasonable cost-of-living modification or divorce, were deemed in private letter rulings to be reasonable modifications not violating the intent of Notice 89-25. Conversely, taxpayers that tried to circumvent the intent of the notice were subject to the harsh consequences of section 72(t)(4).

For potential early retirees, the substantially equal periodic payment exception may provide funding. To be on the safe side, it is imperative to not modify the substantially equal periodic payments. Considering the risks of a misstep, a private letter ruling on the specific facts of a case would most likely be worth the cost.