The early withdrawal 10 percent penalty tax for distributions before age 59-1/2 from a qualified retirement plan or an IRA does not apply to distributions that are part of a series of substantially equal periodic payments that are made at least annually for:
• The life (or life expectancy) of the account owner; or,
• The joint and last survivor life of the account owner and his or her designated beneficiary.
In recently issued Rev. Rul. 2002-62, the Internal Revenue Service says that payments will be treated as substantially equal periodic payments if they are made according to one of the following methods:
(1) The annual payment may be determined using a method that would be acceptable for purposes of calculating the minimum distribution required under IRC § 401(a)(9).
(2) The amount to be distributed annually may be determined by amortizing the taxpayer’s account balance over a number of years that equals the life expectancy of the account owner or the joint life and last survivor expectancy of the account owner and his or her beneficiary. The annual amount must also be based on an interest rate that does not exceed a reasonable interest rate on the date payments begin.
(3) The amount to be distributed annually is determined by dividing the taxpayer’s account balance by an annuity factor. The factor would be the present value of an annuity of $1 per year beginning at the age the taxpayer attained in the first distribution year and continuing for the life of the taxpayer (or the joint lives of the taxpayer and the taxpayer’s beneficiary). The annuity factor must be derived by using the mortality table set out in Appendix B to Rev. Rul. 2002-62 and using the chosen interest rate. See below for the interest rate that may be used.
Observation: I’m not clear as to what Rev. Rul. 2002-62 means when it refers to joint lives with respect to the annuitization method since it only refers to the taxpayer’s age. Also, the table in Appendix B is called "Mortality Table Used to Formulate the Single Life Table in §1.401(a)(9)-9, Q&A-1." Notice 89-25, which previously set out how the annuitization method works, did not refer to joint lives.
The second and third methods described above result in a fixed amount having to be distributed each year. This is because the annual payment is based on the value when distributions begin, and that payment is not increased if the value of the account goes up and is not decreased if the value goes down. These methods could result in the entire account being distributed years earlier than expected if the value of the account declines.
The interest rate that may be used in determining the payment under the second or third methods is any interest rate that is not more than 120 percent of the federal mid-term rate for either of the two months immediately before the month in which the distribution begins.
Observation: The higher the interest rate, the higher the payment that has to be made.
Observation: During a period when stock prices were rising, many account owners chose the amortization or annuitization methods to determine the payments they were going to receive in the belief that total distributions would be less than if the required minimum distribution method were used.
The 10 percent penalty tax applies to earlier distributions if the equal payments are substantially modified (other than by reason of death or disability):
• Before the close of the five-year period beginning with the date of the first payment and after the employee or IRA owner attains age 59-1/2, or
• Before the employee or IRA owner attains age 59-1/2.
The service now says (in Rev. Rul. 2002-62) that an individual who used (or uses in the future) the amortization or annuitization methods to compute substantially equal payments may make a one-time switch to the required minimum distribution method without being subject to the early withdrawal penalty. An account owner who started receiving payments before 2003 may make the switch to the required minimum distribution method at any time.
Once the switch is made, the account owner must continue to use the required minimum distribution method to make distributions, and cannot switch back to one of the other methods without being subject to the 10 percent penalty tax.
The service also shows how the required minimum distribution method works in light of the recently issued final regs on required minimum distributions, and provides guidance on reasonable interest rates, and gives a choice of mortality tables that can be used for any of the distribution methods. The opportunity to switch to the required minimum distribution method can prevent an account that has substantially declined in value from the time the individual started taking early distributions under the amortization or annuitization methods from having to be completely distributed.
Caution: Once the switch is made, if the value of the account goes up substantially, the result could be higher payments in some later years than would have been required under the original method.
How the required minimum distribution method works
If the account owner switches to the required minimum distribution method, the annual payment for each year is determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. The account balance, the factor from the chosen life expectancy table, and the resulting annual payments are redetermined for each year. When this method is used, there is no modification in the series of substantially equal periodic payments even if the amount of the payments changes from year to year.
The required distribution is not determined in exactly the same way as it would be determined if the account owner were determining the required minimum distributions that have to be taken starting with the year he or she become 70-1/2 (or at least by April 1 of the following year). Here are the key differences:
In determining required minimum distributions for the year the account owner becomes 70-1/2 and later years, the taxpayer usually uses the Uniform Life Table set out in Reg § 1.401(a)(9)-9, Q & A 2. This table shows the distribution period where the account owner is 70 and older. The distribution period equals the joint and last survivor life expectancy where a deemed designated beneficiary is exactly 10 years younger than the account owner. However, if the account owner’s spouse is the designated beneficiary and is more than 10 years younger than the account owner, the actual life expectancy from the joint and last survivor table in Reg § 1.401(a)(9)-9, Q & A 3, may be used. Its use will result in a smaller required distribution. In determining the required minimum distribution when an account owner switches from the amortization or annuitization methods to the required minimum distribution method, the following life expectancy tables may be used to determine the distribution period.
• The uniform lifetime table in Appendix A of Rev. Rul. 2002-62. This table is similar to the Uniform Life Table set out in Reg § 1.401(a)(9)-9, Q & A 2, in that it is also a joint and last survivor table where the designated beneficiary is exactly 10 years younger than the account owner. However, life expectancies where the account owner is under 70 are also included.
• The joint and last survivor table in Reg. § 1.401(a)(9)-9, Q&A-3. This table can be used even if the designated beneficiary is not the account owner’s spouse, and the actual age of the beneficiary is used. Depending on whether the account owner is older or younger than the designated beneficiary and the difference in the ages of the account owner and the designated beneficiary, use of this table can result in either a larger or smaller required minimum distribution than use of the uniform lifetime table.
• The single life table in Reg. § 1.401(a)(9)-9, Q&A-1, i.e., the same table that is used to determine required minimum distributions after the account owner dies. Use of this table will result in a larger required minimum distribution than would be required if either the uniform lifetime table or the joint and last survivor table is used.
The number that is used for a distribution year is the number shown from the table for the account owner’s age on his or her birthday in that year. If the joint and survivor table is being used, the age of the beneficiary on the beneficiary’s birthday in that year is also used. The same life expectancy table that is used for the first distribution year must be used in each following year.
If the joint life and last survivor table is used, the survivor must be the actual beneficiary of the account owner for the year of the distribution. If there is more than one beneficiary, the identity and age of the beneficiary are determined under the rules for determining the designated beneficiary for purposes of the minimum distribution rules of Code Sec. 401(a)(9). The beneficiary is determined for a year as of Jan. 1 of that year, without regard to changes in the beneficiary in that year or beneficiary determinations in prior years. However, if the account owner used the joint and last survivor table initially to determine his beneficiary, and in a later year has no beneficiary, in that later year the single life table must be used.
In determining required minimum distributions for the year the account owner becomes 70-1/2 and later years, the account balance as of Dec. 31 of the year before the required distribution is used to determine the amount of the distribution. In determining required minimum distributions for purposes of the substantially equal periodic payments rule, the account balance used to determine payments must be determined in a reasonable manner based on the facts and circumstances. Rev. Rul. 2002-62 says that if the first required minimum distribution were to be made on July 15, 2003 the distribution could be "based on the value of the IRA from Dec. 31, 2002, to July 15, 2003." This seems to mean that the IRA owner can use the value on any day between Dec. 31, 2002, and July 15, 2003. For later years, Rev. Rul. 2002-62 says that "it would be reasonable to use the value either on Dec. 31 of the prior year or on a date within a reasonable period before that year’s distribution."
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