by Gregory Kolojeski and Patrick Matthews
© 2004, Brentmark Software, Inc. All Rights Reserved.
Internal Revenue Code §72(t) provides several exceptions to the 10% tax penalty that is normally applied to pre-59½ distributions from qualified retirement plans. §72(t)(2)(A)(iv) provides that no penalty will be applied to “Distributions which are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or joint lives (or joint life expectancies) of such employee and his designated beneficiary.”
Section 2 of Rev. Rul. 2002-62 (2002-42 IRB 710, 10/21/2002) provides three calculation methods that may be used to comply as substantially equal periodic payments: the required minimum distribution method, the fixed amortization method, and the fixed annuitization method. These are the same three methods previously allowed in IRS Notice 89-25, 1989-1 C.B. 662. However, Rev. Rul. 2002-62 provided new rules as to what life expectancy tables and interest rates must be used.
The question of what constitutes a substantially equal periodic payment is quite simple in the case of annual payments. You use one of the three allowable methods to come up with a value for the annual payment and that is it. The required minimum distribution method will yield a value that changes every year since it uses a varying account balance and a varying life expectancy value. The other two methods, which use actuarial formulas, will yield values that will be the same for every year. However, things get more interesting if payments are to be made more frequently than annually (e.g., weekly, monthly, quarterly, or semiannually). In practice, many taxpayers will prefer to take payments on a monthly basis rather than annually.
May substantially equal periodic payments be made more frequently than annually? The answer is clearly yes as IRC §72(t) provides that payments be made “not less frequently than annually” and IRS practice has long permitted such payments in this area. Another question is whether payments more frequent than annually can be used with each of the three permitted payment methods? The answer is clearly yes for the actuarial formula methods (fixed amortization and fixed annuitization) that have such periodic payments implicit in their very formulas. The answer is less clear for the required minimum distribution method.
Required Minimum Distribution Method
The required minimum distribution method is by its very nature an annual amount. A balance on a certain date is divided by an appropriate life expectancy value and the total distribution is determined. There is no provision for a lesser amount for a short period. At the same time, there is no restriction as to when required minimum distributions may be made during the following year. Yet, varying the distributions might run afoul of the substantially equal periodic payment requirements of §72(t) and Rev. Rul. 2002-62.
Let’s look at an example to see what problems might arise. Let’s assume that the required minimum distribution calculation results in a $12,000 distribution amount. If that payment (and future payment amounts) is made annually on the same date each year, there is no problem. If that amount is divided by 12 and a payment of $1,000 is made every month for a total of $12,000 in the first calendar year, there is no problem. However, what if one desires to make monthly payments with the first year’s payment starting in December? Could one make a distribution of only $1,000 in the first calendar year? A distribution of $1,000 would appear to be a violation of the required minimum distribution method which by its very nature requires the distribution of a full year’s amount for each “calendar” year (e.g., see Treas. Regs. §1.401(a)(9)-2, A-1(c)). Since there is no IRS practice or other substantive authority to rely on, it would be a risky endeavor to set up a payment of less than $12,000 in the first calendar year without first obtaining further guidance such as a private letter ruling. It may be that the IRS will ultimately permit such a distribution in the first payment year when the required minimum distribution method is used, but there is currently no clear authority for that position.
Fixed Amortization and Fixed Annuitization Methods
The actuarial formulas used for the fixed amortization and fixed annuitization methods implicitly provide for precise calculation of periodic payments such as monthly payments. (It should be noted that, once calculated, the monthly amount that is distributed must remain constant.) The IRS has even allowed the use of less precise methodology in some cases. (For example, see private letter rulings 200105066 and 200106039 that simply provided for dividing an annual amortization amount by 12 to determine the monthly payments.) PLR 200105066 provided for a monthly payment that resulted in only six monthly payments being made in the first year of §72(t) distributions. PLR 200106039 provided for a monthly payment that resulted in eleven monthly distributions being made in the first year of §72(t) distributions. It is clear that the IRS has permitted monthly distributions for a first short year (i.e., less than twelve monthly distributions are made) of §72(t) distributions. The question then arises whether Rev. Rul. 2002-62 changes this?
Rev. Rul. 2002-62 (like its predecessor IRS Notice 89-25) does not deal specifically with cases where payments are made more frequently than annually. Its language and examples deal with the easiest case—the annual distribution. Rev. Rul. 2002-62 does reference the “not less frequently than annually” language of IRC §72(t). Furthermore, Rev. Rul. 2002-62 does not contain any language which changes prior practice regarding payments made more frequently than annually. Rev. Rul. 2002-62 does not refer specifically to “calendar” years. Finally, informal consultation with the IRS has revealed that payments more frequently than annually (such as monthly payments) are permitted for a first payment year that is less than a full twelve months. In fact, informal consultation with the IRS has resulted in the expressed opinion that payment of a full twelve months distribution amount in a short first year would be a clear violation of the “substantially equal periodic payments” requirement for the fixed amortization and fixed annuitization methods.
There is considerable authority that §72(t) payments more frequent than annual should and must total less than a full year’s payments for a first (and last) short year when the fixed amortization and fixed annuitization methods are used. If another position is to be considered that would result in a higher distribution for the short year, it is recommended that an application for a private letter ruling be considered. However, it does seem unlikely that a favorable ruling would be received.
As for short year distributions using the required minimum distribution method, there is authority under the final minimum distribution regulations that suggest that every calendar year’s distribution amount must be for the full year’s payment amount. However, it is possible that the IRS may change this rule for §72(t) payments in the same way that Rev. Rul. 2002-62 overrides the December 31st rule for the determination of account balances (see Section 2.02(d) of Rev. Rul. 2002-62) for §72(t) payments. Therefore, it may be a good idea to obtain a private letter ruling for any short year distribution under the required minimum distribution method until such time as the IRS issues further guidance.
Gregory Kolojeski, J.D., M.S., is the founder and President of Brentmark Software, Inc.
Note: PLR 200105066 and PLR 200106039 may be retrieved from the IRS site by clicking on the links in this sentence. Other private letter rulings may also be found at http://www.irs.gov/foia/lists/0,,id=97705,00.html. (Be patient as that retrieval page generally loads very slowly.)
Brentmark Software has retirement planning software products that handle the calculations for §72(t) payments in great detail: Retirement Plan Analyzer and Retirement Distributions Planner. The §72(t) calculations are also available in web-based versions. Contact Brentmark Software for additional information.
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