Early Distribution

When calculating your Series of Substantially Equal Periodic Payments (SOSEPP), provided for under §72(t)(2)(A)(iv) of the Internal Revenue Code, one of your choices is the Fixed Annuitization method.

Calculating your annual payment under this method requires you to have the balance of your IRA account and an annuity factor, which is found in Appendix B of Rev. Ruling 2002-62 using the age you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under the Fixed Annuitization method, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

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When calculating your Series of Substantially Equal Periodic Payments (SOSEPP), provided for under §72(t)(2)(A)(iv) of the Internal Revenue Code, one of your choices is the Fixed Amortization method.

Calculating your annual payment under this method requires you to have the balance of your IRA account, from which you then create an amortization schedule over a specified number of years equal to your life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under the Fixed Amortization method, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

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The Required Minimum Distribution method for calculating your Series of Substantially Equal Periodic Payments (under §72(t)(2)(A)(iv)) calculates the specific amount that you must withdraw from your IRA (or other retirement plan) each year, based upon your account balance at the end of the previous year, divided by the life expectency factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year. This annual amount will be different each year.

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The IRS allows you to change your Series of Substantially Equal Periodic Payments (SOSEPP) allowed under §72(t)(2)(A)(iv) – one time, and only one time. And then, you’re only allowed to change your method from either the fixed annuitization method or the fixed amortization method to the Required Minimum Distribution method.

This is the only exception allowed for making a change to your SOSEPP during its enforcement period, which is the later of five years after you started the SOSEPP or when you turn age 59 1/2. The exception is documented in Rev. Ruling 2002-62, 2.03(b).

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This particular section of the Internal Revenue Code – specifically §72(t)(2)(A)(iv) – is the most famous of the 72(t) provisions. This is mostly due to the fact that it seems to be the ultimate answer to the age-old question “How can I take money out of my IRA without penalty?”

While it’s true that this particular code section provides a method for getting at your retirement funds without penalty (and without special circumstances like first-time home purchase or medical issues), this code section is very complicated. With this complication comes a huge potential for costly mistakes – and the IRS is notorious for NOT forgiving and forgetting!

In order to set up your Series of Substantially Equal Periodic Payments (SOSEPP), you must use one of the three methods prescribed by the IRS: Required Minimum Distribution method, Fixed Amortization method, and Fixed Annuitization method. (follow the links for more information on each method)

Once chosen, your method can not be changed under most circumstances. There is one situation that provides for a one-time change to your payments, but in general the SOSEPP can’t be changed. This means that every year the SOSEPP is in effect, you must take exactly the amount in your schedule from your IRA, no more and no less. Making a change to your withdrawal schedule will result in your owing the 10% penalty retroactively on all payments received to that point, plus interest. (this is the place where the IRS does not forgive)

In addition, once you’ve begun your SOSEPP, you must continue that payment schedule until the later of five years or you reach age 59 1/2. Again, this is an area where the IRS doesn’t forgive or give any leeway: if you take additional distributions one day before your five years or 59 1/2th birthday, the action will “bust” the SOSEPP, and you’ll be liable for 10% penalty on all distributions from your IRA plus penalties. Obviously this sort of an arrangement should not be taken lightly, and you must keep excellent, flawless records on your withdrawals.

Other facts about §72(t)(2)(A)(iv):

• You can split your IRA into more than one account, and apply your SOSEPP against only one account, thereby reducing the balance against which your payout method is calculated.
• You can have more than one SOSEPP going at a time, using separate IRA accounts and different payout methods for each.
• Your periodic payment could change under the minimum distribution method, as it recalculates annually based on the account balance at the end of the prior year.

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Three of the most common ways that you can withdraw funds from your IRA without penalty are – reaching age 59 1/2, death, and disability.

When you reach age 59 1/2, you can withdraw any amount of your IRA (or other deferred account) without penalty, for any reason. The only thing you have to remember is that you must pay ordinary income tax on the amount that you withdraw. This means that, once you have reached the date that is 6 months past your 59th birthday, you are free to make withdrawals from your IRA without penalty.

Upon your death at any age, your beneficiaries of your account, or your estate if you have not named a beneficiary, can take distributions from your IRA in any amount for any reason without penalty.

In addition, if you are deemed “totally and permanently disabled” you are also eligible to withdraw IRA assets for any purpose without penalty. Total and permanent disability means that you have been examined by a physician and the disability is such that you can not work, and the condition is expected to last for at least one year or result in your death.

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In our first post about early withdrawal from an IRA, we mentioned that there were several exceptions in the Internal Revenue Code that allow an early withdrawal from your IRA or 401(k) without the 10% penalty being imposed. The section of the IRC that deals with quite a few of these exceptions is called Section 72(t) (referred to as §72(t) for short), and there are several subsections in this piece of the Code. Each subsection, listed below, has specific circumstances that must be met in order to provide exception to the 10% penalty. Clicking on the link for each subsection will provide you with additional details about that exception.

§72(t)(2)(A)(i) – age 59 1/2.

§72(t)(2)(A)(ii) – death at any age.

§72(t)(2)(A)(iii) – disability at any age.

§72(t)(2)(A)(iv) – series of substantially equal periodic payments (SOSEPP).

§72(t)(2)(A)(v) – separation from service on or after age 55 (401(k) only).

§72(t)(2)(A)(vi) – 404(k) dividends.

§72(t)(2)(A)(vii) – levy on a qualified plan

§72(t)(2)(B) – medical expenses.

§72(t)(2)(C) – qualified domestic relations order (QDRO) – upon a divorce settlement

§72(t)(2)(D) – health insurance premiums.

§72(t)(2)(E) – higher education expenses.

§72(t)(2)(F) – first time home purchase

In another post we’ll go into the details of §72(t)(4), which describes the penalties and circumstances surrounding making changes to the SOSEPP (described in §72(t)(2)(A)(iv)), which can be quite severe, and which can take up quite a bit of time to discuss. For now, the sections above should suffice to keep us busy for a while.

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Normally, when you’ve put money into an IRA (or 401(k), or other deferred compensation arrangement), you are allowed to begin taking withdrawals once you’ve reached age 59 1/2. But sometimes you’d like to take your money out earlier… and you’ve probably already discovered that there is a 10% penalty for taking funds out of your IRA early, right? So – is there a way to avoid that penalty?

Yes – there are several ways, as a matter of fact. There are several sections of the Internal Revenue Code that deal with these early distributions – including 72(t) (which we’ll cover in depth in another post), first time home purchase, high medical expenses (including medical insurance), disability, and others. We’ll explain the first time home purchase in this post, and cover the remainder of the exceptions in other posts.

First Time Home Purchase

If you are buying, building, or re-building your first home (defined later), you are allowed to take a distribution of up to $10,000 (or $20,000 for a married couple) from your IRA to fund a portion of your costs, without paying the 10% penalty. There are a few restrictions, though – here is the official wording from the IRS:

1. It must be used to pay qualified acquisition costs (defined later) before the close of the 120th day after the day you received it.
2. It must be used to pay qualified acquisition costs for the main home of a first-time homebuyer (defined later) who is any of the following.
   1. Yourself.
   2. Your spouse.
   3. Your or your spouse’s child.
   4. Your or your spouse’s grandchild.
   5. Your or your spouse’s parent or other ancestor.
3. When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.

If both you and your spouse are first-time homebuyers (defined later), each of you can receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.

Qualified acquisition costs. Qualified acquisition costs include the following items.

• Costs of buying, building, or rebuilding a home.
• Any usual or reasonable settlement, financing, or other closing costs.

First-time homebuyer. Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement.

Date of acquisition. The date of acquisition is the date that:

• You enter into a binding contract to buy the main home for which the distribution is being used, or
• The building or rebuilding of the main home for which the distribution is being used begins.

The keys here are to make sure that you qualify as a first-time homebuyer (by the IRS’ definition above), that you use the funds in time (before 120 days has passed), and that you haven’t taken this option previously. For many folks this can be very helpful in funding the purchase of a home.

Another important point here is that you need to understand that although you do not have to pay the 10% penalty on the distribution, you WILL be required to pay ordinary income tax on any money taken from your IRA. This can be a surprise to some folks who weren’t expecting it.

If you’d like to learn more about this and other options with your IRA, you can check out IRS Publication 590.

Photo by nbii.gov

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