Annuity Purchase and Avoiding 10% Tax Penalty by Meeting the "Substantially Equal" Test

Written by Hersh Stern Updated Tuesday, October 29, 2024

The choice to amortize a portion, rather than all, of the IRA balance over the joint life expectancy of an IRA owner and his beneficiary invoked the 10% early withdrawal penalty, as concluded by the IRS in a private ruling that the tax on early withdrawals applied to this series of annual distributions. (IRS Letter Ruling 9705033)

An additional 10% tax is imposed on IRA distributions made before the owner reach age 59½, with some exceptions. Code Sec. 72(t)(2)(A)(iv) provides one exception: the additional tax doesn't apply to distributions that are part of a series of substantially equal periodic payments over the life (or life expectancy) of the IRA owner, or the joint lives (or joint life expectancies) of the IRA owner and his beneficiary.

In Notice 89-25, Q&A 12, the IRS set out three acceptable methods for determining substantially equally periodic payments. One method is the amortization of the IRA Owner and beneficiary at no more than a reasonable interest rate.

Observation:

The higher the interest rate assumption, the larger the annual distributions would be.

The taxpayer (call him Harry) retired in 1994, apparently at age 56. He rolled over a distribution from his employer's profit-sharing plan into two separate IRAs maintained by one financial institution. The aggregate IRA account balance was $461,991 on December 31, 1994. In accordance with his financial adviser's calculations, Harry withdrew $30,000 from the IRAs in 1995 as the first of a series of annual payments that were intended to meet the substantially equal periodic payment exception to the 10% early distribution tax.

But the IRS ruled that the 10 early distribution tax applied to the $30,000 distribution because Notice 89-25 requires the amortization of the entire IRA account balance over the applicable life expectancy. The worksheet of Harry's financial adviser showed that he arrived at the $30,000 annual distribution by amortizing $405,954, a portion of Harry's IRA account balances, over the joint life expectancy of Harry and his 58-year old wife, using a 7% interest rate.

Recommendation:

An individual planning to begin a series of periodic IRA distributions intended to satisfy Notice 89-25 should calculate the account balance necessary to support the desired distribution, and then make sure the IRA balance equals that amount when distributions begin. Here, Harry could have easily avoided the 10% early withdrawal tax by dividing his assets between his IRAs so that one (or more) of his IRAs had a value of $405,954 on December 31, 1994 (or any other date that he chose to begin annual distributions).

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Recommendation:

Even if an IRA owner is unable to divide his IRA into separate IRAs to achieve the desired account balance, the IRA owner can reduce the annual distribution to the desired level by reducing the assumed interest rate. Notice 89-25 prevents the use of an interest rate that exceeds a reasonable interest rate, but it doesn't prevent the use of a lower (or even 0%) interest rate. Here, even if Harry was unable to structure an IRA account balance of $405,954 by December 31, 1994, he still could have achieved his goal of a $30,000 annual distribution by using and interest rate lower than 7%. Thus, Harry could have backed into his desired annual distribution amount by calculating the interest rate that would amortize $461,991 by annual distributions of $30,000 over 32 years, the joint life expectancy of Harry and his wife.

Observation:

Also, Harry could have left his account balance in his employer's profit-sharing plan at retirement. Then, if the plan allowed, he could have made profit sharing plan withdrawals in any amount at any time without being subject to the 10% early withdrawal tax. Under Code Sec. 72(t)(2)(A)(v), the 10% early withdrawal tax doesn't apply to distribution from qualified retirement plans made to a retired employee after reaching age 55.