We recently worked with an investor who was 54 and was “worked out of his job” when his company was bought. With his specialized skills, he didn’t want to start over with a new job. In five years, his wife would retire at 63 and receive Social Security and her pension. Until then, he wanted to withdraw from his retirement account but didn’t want to incur the 10% early-withdrawal penalty.
Normally, we want to see investors use after-tax investments in brokerage accounts first. However, like many investors, he had all his savings in tax-deferred accounts.
We explored one of the exceptions to the early-withdrawal penalty under Section 72(t), substantially equal periodic payments. These payments are required for at least five years or until the investor reaches 59 ½, whichever is later. Fortunately for this investor, 59 ½ was also five years away, making this strategy appealing.
We explained all he had to do was select the appropriate life expectancy table; select an interest rate—but only if he was using the fixed amortization or fixed annuitization methods; determine his retirement account balance, and apply an IRS-approved calculation method. When he files taxes, he’d need to make sure his 1099-R indicates he met one of the exceptions; complete Form 5329, and attach it to his federal return.
The harsh reality is this strategy is complicated and requires a professional’s attention. First, we had to determine how much was needed to fulfill the spending needs for the five years he’s required to make withdrawals. We also calculated withdrawals using all three IRS-approved methods to see which one was most advantageous.
The IRS allows substantially equal periodic payments to be calculated using one of three methods. The required minimum distribution method is calculated much like a normal RMD—the balance of the IRA on a specific date divided by a life expectancy factor. This number is recalculated each year; therefore, the withdrawal could vary depending on market performance or the age of the designated beneficiary.
The fixed amortization method yields a fixed amount annually, calculated by amortizing your IRA balance in level amounts over a specified number of years determined by the life expectancy table and interest rate selected.
Finally, the fixed annuitization method also yields a fixed amount but is the most complicated to calculate. The withdrawal derives from determining the appropriate account balance, choosing an applicable interest rate, and determining the annuity factor using the mortality table in Revenue Ruling 2002-62.
Furthermore, once an investor chooses a method, the investor generally must stick with it for the duration of the payments; otherwise, a 10% premature distribution tax will be due on all withdrawals taken. One rule in the investor’s favor is that multiple IRA accounts are not required to be aggregated to determine the value. An investor can separate the money needed into a new IRA and only apply this strategy to a specific balance—allowing for more control on how much is withdrawn.
It s a complicated strategy, requiring a financial adviser to help with calculations and to determine if the strategy is appropriate for the investor’s circumstances. It also requires a tax adviser to ensure all I’s are dotted and T’s crossed so the 10% penalty is not triggered.
If you have questions on using substantially equal periodic payments, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
