Annuitizing an IRA

Taking penalty free withdrawals prior to age 59½

The tax law imposes a 10% excise on any distribution from an IRA, prior to attaining age 59½. One of the exceptions to the 10% tax is to annuitize the IRA, that is, take withdrawals as "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 the joint lives (or joint life expectancies) of such employee and his designated beneficiary". (Sec 72(t)(2)(A)(iv)). The payments, once started, must continue at least five years, or until the account holder reaches age 59½, which comes last. The series of payments cannot be substantially modified, either up or down, other than be reason of death or disability. Failure to follow the rules will result in the imposition of the 10% excise tax on all withdrawals previously taken, not subject to the tax by reason of these rules. In addition, interest will be charged to take into account the fact that tax was not paid in prior years when it otherwise would have been due. (Sec 72(t)(4)).

The rules for computing the series of substantially equal payments are found in IRS Notice 89-25. The notice provides three methods of computing the payments.

The first method computes the annual payment by dividing the IRA balance as of the previous December 31^st by the life expectancy of the account holder, or the joint life expectancy of the account holder and the beneficiary. This is similar to the way the minimum distribution is calculated for taxpayers who have reached their required beginning date at age 70½. Under this method, each subsequent year's distribution is recomputed based upon the new account balance and the reduced life expectancy.

The second method amortizes the account balance over the life expectancy or joint life expectancies, assuming a reasonable interest rate. Once computed, this withdrawal cannot be substantially changed in subsequent years.

The third method amortizes the account balance over an insurance mortality table, assuming a reasonable interest rate. There is no provision in this method for a joint life expectancy, and once computed, the amount of the annual withdrawal will not change.

The results using each of the methods can differ substantially. To illustrate, assume an individual age 50 who has an IRA balance of $500K. His wife is 48, and the reasonable interest rate is 7%. He will use the joint life expectancy for the first and second methods (it is not applicable to the third method). The first method will result in a withdrawal in the first year of $12,438. This amount will change, most likely increase, in subsequent years. The second method will result in annual withdrawals of $37,469. The third method will result in annual withdrawals of $35,594. The annual withdrawals in the second and third methods will not change in subsequent years (but see below). As previously pointed out, any substantial modification of the amount withdrawn, prior to reaching age 59½ or having taken distributions for five years, (unless the modification is due to death or disability), will result in the 10% excise tax being imposed on all current and previous withdrawals, plus an additional amount to reflect interest.

It is important to note that the five year requirement runs from the date of the first withdrawal. So that no modification can be made prior to the fifth anniversary of that withdrawal. To illustrate, assume an individual started withdrawing from her IRA when she was age 56½, in November, 1994. She took her first annual withdrawal that month, and then took her second annual withdrawal in January, 1995, and took annual withdrawals in each subsequent January. Her fifth annual withdrawal was therefore taken in January, 1998. Even though five annual withdrawals have been taken, and the taxpayer is now over the age of 59½, the withdrawal plan cannot be modified until after the anniversary date in November, 1999. Any modification prior to that date in November, 1999 will result in the 10% penalty being imposed on the pre age 59½ withdrawals, but not on those taken after that date.

Prior to selecting a method to compute the substantially equal withdrawals, the taxpayer should analyze which of the methods will produce the results that will meet his or her needs. For example, the second or third method results in an unchanging amount. If the taxpayer finds in a few years that inflation has accelerated, the taxpayer still cannot increase the annual withdrawals. On the other hand, the first method will vary each year, and will be affected by the investment results in the IRA account. However, as noted below, in one case the IRS approved a withdrawal plan that permitted the taxpayer using the third method to increase each year's withdrawal by 3% to reflect inflation. Presumably that would apply to the second method also. But in a court case where the taxpayer tried to explain an extra withdrawal prior to the end of the five year period as an inflation adjustment, the court ruled that a one time withdrawal in year five, did not constitute a proper inflation adjustment.

It is important to note why the taxpayer is electing to take the early withdrawals. At one time, taxpayers with large account balances would opt to take the early withdrawals as a means of insuring that they did not get hit for the 15% excess withdrawal tax in later years. With that tax having been repealed, this is no longer an issue. Also, if the taxpayer merely needs money now for a non recurring purpose, it may make more sense for the taxpayer to incur the 10% early withdrawal tax, rather then be forced to take annual distributions that are not needed. For example, if a 50 year taxpayer has a one time need for $30K, he may decide to annuitize his IRA using the second method, setting him up for annual withdrawals of approximately $37,000. However he will lock himself into another 8 or 9 withdrawals of this amount, that he may not need. He would most likely be better off taking one withdrawal for the $30K he needs and paying the $3K excise tax, and letting the balance of the IRA sit untouched with tax deferred growth. As much as taxpayers hate to pay taxes, the tax deferred growth will easily cover the $3K excise tax.

In addition to the flexibility available by means of three methods of computing the substantially equal payments, the IRS has been fairly lenient to taxpayers in their letter rulings. A taxpayer is permitted to divide his IRA separate accounts, and then compute the substantially equal payments on one or more, but not all, of the IRA accounts. In Letter Ruling 9812038, a taxpayer who was already receiving substantially equal payments from one IRA account (IRA 1), was permitted to create a new IRA account (from IRA money NOT in the account that was already being distributed), and then start taking substantially equal payments from the new IRA account. The IRS said the accounts would NOT be aggregated, and that each IRA, viewed separately, met the requirements of Notice 89-25. Additionally, the commencement of substantially equal payments from the new IRA account, would NOT constitute a substantial modification of the substantially equal payments currently being taken from the IRA 1.

But contrast the above with Letter Ruling 9705033 where the taxpayer computed the substantially equal payments on a portion of an IRA account. The IRS stated in that ruling that a taxpayer could use one or more IRA accounts to compute the substantially equal payments; if more than one IRA account is used, the distribution can be taken from any of the IRA included in the computation (but from no other IRA account), and need not be taken ratably from each account. But for any account included in the computation, the entire account must be included. Using a portion of the account failed to constitute a valid computation, and subjected the taxpayer to the 10% excise tax on the amount withdrawn.

Also note that while the second and third methods result in an unchanging annual withdrawal, the IRS permitted the taxpayer in Letter Ruling 9723035 to utilize the third method, and include a 3% annual inflation factor (each year's withdrawal was 3% greater than the previous year's withdrawal). This is a good plan to get slightly higher withdrawals each year, assuming you use a rate of inflation that is consistent with the Consumer Price Index (CPI). It might even be possible to set up a early withdrawal plan tied to the CPI, but I would strongly suggest anyone contemplating such a plan get advanced approval from the IRS.

On the surface, annuitizing an IRA appears straightforward and simple. However, once instituted, it is fairly inflexible. The entire situation should be carefully analyzed prior to getting locked into a program that will not meet the taxpayer's needs a few years down the road. In Letter Ruling 199909059, a 44 year taxpayer started taking annual withdrawals from his IRA. Five years later, he wished to modify the program and change the method. The IRS approved his new method of computing his annual withdrawals, but the cost was paying the 10% plus interest on all prior withdrawals. Proper planning may have been able to avoid the penalty while still achieving the desired withdrawals.