Substantially Equal Periodic Payments Exception to the 10% Penalty

Yesterday’s post was sort of a catalogue of exceptions to the 10% penalty tax on distributions from tax-favored retirement plans before age 59-1/2. Only one of those exceptions is within your control: Substantially equal periodic payments. Sometimes jargon-loving financial planners call this the “72(t) exception.”

Today’s post provides an overview of the exception; tomorrow I will go into how you actually calculate distributions that qualify. So here goes the overview.

You may take distributions from a tax-favored retirement plan at any time, without incurring the 10% penalty tax, if the distributions are structured as a series of distributions and the series consists of substantially equal periodic payments. These are rather strict requirements. And you will find that this technique for avoiding a penalty tax will not result in a large immediate distribution, so it will not be suitable if you’re looking to gain immediate access to a large chunk of your IRA. Rather, it can work well—if somewhat inflexibly—if you’re under 59-1/2 and you’re looking to spread your distributions over your lifetime.

Triggering event. If the distributions come from a traditional or Roth Individual Retirement Account, they do not have to be triggered by any particular event. You may start them at any time and any age. However, if they come out of an employer plan, to qualify they must begin after you have separated from service with the employer. Since most employer plans do not offer participants the option to take distributions in flexible ways, you are unlikely to be applying this exception to employer plan distributions. More likely, if you utilize this distribution method, it will be from an IRA.

Frequency of distributions. To qualify, the series of distributions must be periodic, no less frequently than annually. A series of monthly or quarterly distributions may also qualify.

Term of distributions. To qualify, the series must be calculated to occur over one of the following terms:
• Your life expectancy (more on this tomorrow)
• The joint life expectancy of you and your beneficiary
• Your actual lifetime (i.e., in the form of a life annuity)
• The actual lifetime of you and your beneficiary (i.e., in the form of a joint and survivor annuity).

Separate IRAs. In private letter rulings, the IRS has been liberal in allowing someone with two IRAs to calculate substantially equal periodic payments separately for one of the IRAs, while leaving the other IRA untouched; or alternatively, aggregating the IRAs for purposes of calculating the distributions.

Modification of periodic payments. Now, here’s the bad news. Once you start taking substantially equal periodic payments from an IRA, you should continue doing so at least until age 59-1/2, or, if later, five years from the initial distribution. If you modify your series of distributions before age 59-1/2 or five years—including ceasing your distributions—the IRS will recapture the 10% penalty tax you would have owed on your prior pre-age 59-1/2 distributions, plus interest on the penalty. Yow!! That hurts!

Exceptions to recapture tax. There are three exceptions to this recapture tax.
• No penalty tax recapture if the modification occurs after the later of age 59-1/2 or five years after you began the series of distributions; then you are free from the strictures of having to follow the method you began with.
• No penalty tax recapture will apply if distributions are modified on account of death or disability. (But those are rather unpleasant ways to avoid a tax.)
• I’ll talk about the third exception tomorrow, as it relates to the method you use for calculating these distributions.

I gotta go water my plants…..