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Nov 1992

Withdrawals from IRA without 10% penalty. (individual retirement accounts) (Personal Financial Planning)(November is Computer Month)

by Crommett, Alfred F.

    Abstract- It is possible for anyone under 59.5 years old to access their tax-deferred individual retirement account (IRA) distributions without being subject to the 10% penalty tax imposed by the Federal Government. To do this, IRA owners must comply with the annuity exemption regulations set forth in IRS Pub 590. Exemption from the 10% penalty tax is not available to IRA owners who are still connected to their employers and those whose source of funds are controlled by qualified employment plans. There are a number of software packages that can be used to plan such withdrawals from IRAs. The RBI software system, for instance, offers a distribution analyzer for pre-59 1/2 IRA owners as well as a retirement funding analyzer. Another helpful program is the IRA Annuity Generator. This generates cash-flow reports for planning retirement withdrawals made at any age above 35.

Distributions from an IRA can be taken by an owner under age 59 1/2 and kept exempt from a 10% IRS penalty. The owner--even if not disabled-- must carefully adhere to the annuity exception rules laid down by the IRS. The rules can be found in IRS Pub. 590. Further elaboration is located in Question & Answer No. 12 of Notice 89-25. This exception can not be used if the source of funds is still under the control of a qualified employment plan and a full separation of the employment relationship has not yet been made (see also IRS Form 5329 and its instructions).

A Record of Owner's Decision Form (table) illustrates the rules that are of concern such as: 1) owner and beneficiary ages; 2) life expectancy per IRS tables; 3) most recent December 31 fund balance (all IRA's in total); 4) date distributions are to begin; 5) a reasonably current interest rate; 6) employment relationship--if any; 7) selection of one of three distribution methods acceptable to the IRS; 8) frequency and amount of the distributions; 9) restriction of the "no modification" rule; and 10) entries to be made every year in Form 5329--Return for Additional Taxes Attributable to Qualified Plants, etc.

The declaration statement can serve not only as documentation of a pre- 59 1/2 withdrawal plan of "substantially equal periodic payments," but it can also serve as clarification to the taxpayer as to the terms of the long-term commitment he or she would make.

Lotus 1-2-3, Excel, or some other spreadsheet program can be used to create the necessary cash-flows needed for evaluation of the strategy. IRS life expectancy tables are also required and can be found in Publication No. 590. See Figures 1, 2, and 3 for a suggested cash flow format.

The RBI software system provides a pre-59 1/2 distribution analyzer and a retirement funding analyzer. This system consists of several spreadsheet templates with menus and requires an MS-DOS operating system. An MS-DOS software package called the IRA Annuity Generator is specifically designed to provide cash-flow reports for retirement withdrawal analysis TABULAR DATA OMITTED TABULAR DATA OMITTED TABULAR DATA OMITTED TABULAR DATA OMITTED at any age above 35. Cash flow reporting is also available for funding retirement in the future. A comparison of the RBI software with the IRA Annuity Generator software is shown in Figure 4.

Once started, a pre-59 1/2 withdrawal plan can not be modified for either five years or until the owner reaches age 59 1/2, whichever period is longer. A client may be willing to handle this constraint, if the need for cash is great. For example, a family whose borrowing power is exhausted but needs help with college expenses, an entrepreneur needs cash while starting a new business, and drugs or medical procedure expenses not covered by medical insurance. The planner who makes the annuity suggestion to such clients may perform a valuable service.

Before undertaking such a long-term obligation, a printed forecast will be very helpful to visualize the flow of cash for each year of the "no modification" period. Q & A No. 12 in Notice #89-25 cites an example of a 50 year old taxpayer with $100,000 in his IRA who decides to use the amortization over life expectancy withdrawal method. In the IRS tables, he finds that his single life expectancy is 33.1 years. Using a "reasonable" interest rate of 8%, he finds that he could expect a fixed payment distribution of $8,679 per year based on his IRA of $100,000.

Figure 1 forecasts this taxpayer's probable flow of cash for each of his "no modification" years from 50 to 59. (Some years are omitted here for reasons of brevity.) Figure 1 was drawn from a cash flow report printed by the IRA Annuity Generator.

When the owner reaches the end of his 59th year, he will have withdrawn an estimated $86,790 and have a balance of $94,430. Actual interest rates would affect the results. With a cash flow information such as this, the owner can evaluate and decide upon the intended course of action.

For each tax year--to his 59th year--the taxpayer in the example would enter $8,679 in two places on Part II of IRS Form 5329: Once as a qualified distribution and again as an exception of "substantially equal periodic payments." These entries would acknowledge taxable income and reduce the 10% penalty liability to zero.

The planning strategy would not have to stop at age 59 1/2. Beyond the "no modification" stage, the taxpayer could continue the annual payments of $8,679, modify the payments, or modify the plan by stopping the payments to allow the fund to rebuild itself.

If the taxpayer chose to rebuild his IRA, Figure 2 displays the potential results. If $94,430 were left to accrue tax-deferred for 10 years to age 70 1/2, it could grow at 8% to an estimated $226, 997. Here again, actual interest rates would effect the final results.

At age 70 1/2, distributions would have to start again. With a spouse two years younger than the taxpayer, their joint life expectancy from the IRS tables would be 21.5 years. Figure 3 from the IRA Annuity Generator shows how the $226,997--again at 8%--could provide retirement income to age 100.

The IRS minimum distribution formula used in Figure 3, with life expectancies recalculated every year, produces cost-of-living distribution adjustments beginning with the second year. This occurs simply by operation of the IRS formula because December 31 beginning balances are divided by life expectancies that grow smaller each year.

If the taxpayer chose to annuitize the $226,997 on a fixed payment basis, the answer can be found using a hand-held, business-type calculator. The IRA Annuity Generator could also make the calculation, provide printed documentation of the factors used, and a cash flow to report the results as in Figure 1. In this case, $226,997 for 21.5 years could provide a fixed annuity of $22,452 per year, if interest remained constant at 8%.

Note in Figure 3, after 11 years yearly distributions provided by the minimum distribution formula would be greater than those provided by the fixed annuity. Note also that the strategy laid out here in Figures 1, 2, and 3 could be planned at age 50--before the client makes any binding commitment.

More information about the RBI software system is available from The Retirement Benefits Institute, P.O. Box 14310, Cleveland, OH, 44114- 0310, (216) 566-0270 or (216) 621-3480. A dot-matrix printer is required. The software is free with a $195 subscription to the Retirement Benefits Planner.

The IRA Annuity Generator software can be obtained by calling (508) 842- 8154 or by writing to the IRA Annuity Generator at, 32 Bruce Ave., Shrewsbury, MA. 01545-3002. The cost is $69 and is available for MS-DOS computers on either one 5.25|inches or one 3.5|inches floppy disk. A dot-matrix or laser printer is required.

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