Case — Substantially Equal Periodic Payments

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TL Case Summ

THE QUESTION

Do extra IRA distributions used for higher education expenses modify an election to receive substantially equal periodic payments from the IRA, thereby triggering recapture tax?

THE DISPUTE

Taxpayer Says: The additional distributions qualify for a statutory exception to the recapture tax and do not modify the election to receive substantially equal periodic payments.

Internal Revenue Service Says: An employee who elects a series of substantially equal periodic payments is not allowed any further distributions within the first five years of the election irrespective of whether the distribution would qualify for another statutory exception to the tax unless the employee dies or becomes disabled.

THE LAW

From Internal Revenue Code Section 408(d)(1): In general, amounts distributed from an IRA are includable in gross income.

From Internal Revenue Code Section 72(t)(1) and (2): Provides for a 10% additional tax on early distributions from qualified retirement plans, unless the distribution falls within a statutory exception.

From Internal Revenue Code Section 72(t)(2)(A)(iv): Provides an exception from the 10% additional tax for distributions that 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 the joint lives (or joint life expectancies) of such employee and his designated beneficiary”.

From Internal Revenue Code Section 72(t)(4)(A)(ii)(I): If the series of substantially equal periodic payments is modified within five years of the date of the first distribution (other than by reason of death or disability), then the 10% additional tax will be imposed retroactively on prior distributions made before the taxpayer attains age 59-1/2 (referred to as the recapture tax), plus interest.

From Internal Revenue Code Section 72(t)(4)(A)(ii)(II): The recapture tax also applies when a modification occurs after the initial five year period but before the employee has attained age 59-1/2.

From Internal Revenue Code Section 72(t)(2)(E): Provides an exception from the 10% additional tax for distributions for qualified higher education expenses.

THE CAUSE OF THE DISPUTE

In addition to regular income tax, distributions you take from your IRA prior to reaching age 59-1/2 are generally subject to a federal recapture tax of 10% unless you qualify for an exception.

One way you can qualify for an exception to the 10% penalty is by taking annual withdrawals of substantially equal amounts called substantially equally periodic payments. The amount you have to withdraw is calculated using one of three prescribed methods, and it must be withdrawn each year for five years or until you reach age 59-1/2, whichever is later.

If you change your distributions or stop taking them before the required time period is up, the 10% penalty is assessed retroactively to all previous withdrawals. The penalty generally applies unless you die, become disabled, make a one-time switch to the minimum distribution method of withdrawals or use up all your IRA assets in making the distributions.

Other exceptions to the 10% penalty include IRA withdrawals you use to pay certain education expenses.

In this case, the dispute arose over the question of whether taking distributions that are not part of the substantially equal periodic payments but that do meet an exception to the penalty causes a change in the payment schedule.

The taxpayer elected to receive substantially equal periodic payments beginning in 2002, prior to reaching age 59-1/2. During 2004, besides the annual payment, she took two other distributions from her IRA to pay for her son’s college expenses. She contends the additional distributions, which qualify for the higher education expense exception to the 10% penalty, did not modify the series of withdrawals from her IRA, so the substantially equal periodic payment exception continues to apply.

The IRS agrees the additional distributions meet the definition of qualified higher education expenses and are exempt from the 10% penalty. However, the Service believes the additional distributions modify the original payment schedule for the substantially equal periodic payments, and those payments no longer qualify for the exception to the penalty.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 15KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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For the Taxpayer. A distribution that satisfies the statutory exception for higher education expenses is not a modification of a series of substantially equal periodic payments and the five year rule prohibiting modifications except in the case of death or disability is not violated.
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