8/7/2009g
By Barry C. Picker, CPA/PFS, CFP®
Iin
a recent private letter ruling, that could best be described as not
taxpayer friendly, the Internal Revenue Service has ruled that a
transfer of assets from one IRA to another IRA, while the taxpayer is
taking distributions that are part of a series of substantially equal
periodic payments, is an improper modification.
As a result, the taxpayer is subject to the
10% early withdrawal
penalty on all distributions taken from the IRA. Additionally, the
Service ruled that the taxpayer cannot correct the situation by
transferring the assets back to the first IRA.
Facts
The taxpayer in this case, a 56-year-old
woman, maintains two IRA
accounts with the same custodian. In 2002, she commenced taking
distributions from one of the IRAs that was designed to avoid the 10%
penalty for early withdrawals from an IRA. She calculated her annual
distribution amount using the fixed amortization method, which is one
of the approved methods for computing a series of substantially equal
periodic payments, under section 72(t).
At some point, the taxpayer consulted with
her financial advisor to
discuss whether she should move a portion of the equities in the IRA in
question into cash. Her financial advisor informed her that while she
could convert a portion of her IRA into cash without any penalties for
the conversion, he indicated to her that her current IRA custodian did
not offer certificates of deposit as an investment option. He therefore
suggested that she transfer a portion of the IRA to a new custodian.
She then did a trustee to trustee transfer
of a portion of the IRA
to the new custodian. At the same time, however, she also transferred
all of the second, non-72(t) IRA into the same account at the new
custodian.
The taxpayer was subsequently informed that
the transfer she had
made was a modification of her series of substantially equal periodic
payments, which would trigger the 10% penalty, plus interest, on all
distributions taken since 2002.
At that point the taxpayer filed a request
for this private letter
ruling asking that the previous transfers not be considered a
modification, and a proposed transfer back to the original IRA also not
be considered a modification.
Background
Section 72(t) of the Internal Revenue Code
imposes a 10% additional
tax, commonly referred to as a penalty, on early distributions from
retirement plans including IRAs. That section also lists a series of
exceptions to the 10% penalty. One exception, the one in play here, is
that the penalty will not be imposed on early withdrawals if the
taxpayer is taking a series of substantially equal periodic payments
and the payments continue for five years or until the taxpayer attains
age 59 1/2, whichever is longer. However, if the computed distribution
is modified in any way, other than by reason of death or disability,
the 10% penalty will be imposed on all distributions taken prior to the
taxpayer attaining age 59 1/2. In addition, an additional amount equal
to the interest, computed as if the penalty was payable in the early
years, is imposed.
Notice 89-25 and Rev. Rul. 2002-62 offers
guidance on how the series
of substantially equal periodic payments can be calculated. Three
methods are approved for making the calculation. They are the minimum
distribution method, the fixed amortization method, and the fixed
annuitization method.
Rev. Rul. 2002-62 further provides that
under all three methods the
calculation is made with respect to the account balance as of the first
valuation date selected. It further holds that any addition to the
account balance other than through the normal gains or losses, or any
non-taxable transfer in or out of the IRA accounts in question, will be
considered a modification that will trigger the 10% tax.
Discussion
Based upon the facts in this case, the
Service determined that the
taxpayer had made an improper modification when she transferred a
portion of the IRA into a new account. It further ruled that the
taxpayer could not correct this action by reversing the transfer.
It has always been my feeling that the
provision prohibiting
transfers into or out of an IRA that was involved in a series of
substantially equal periodic payments was designed to avoid playing
with the balance if, for example, the account was being depleted due to
poor investment results and the taxpayer wished to continue taking the
same distribution. However, the Service appears to be taking a very
hard line and reading the word "transfer" literally.
In this case, the Service could make a good
argument that a
modification had occurred because of the fact that when a portion of
the involved IRA was transferred to the new custodian the entire
balance of the second IRA was transferred into the same account. This
resulted in a co-mingling of the IRA money from which a series of
substantially equal periodic payments was being taken, with other
non-involved IRA money.
However, the Service did not give the
co-mingling as a reason.
Rather, the Service stated, in the ruling, that the mere transfer of a
portion of the account from one IRA to a second IRA constituted a
modification.
Conclusion
The hard-line that the Service is taking on
this issue makes it
extremely important that individuals who are taking distributions that
are part of a series of substantially equal periodic payments be
vigilant. The penalties for blowing up the plan are significant, and
the IRS is not forgiving.
