This article was published March 1, 1999, last updated on on March 14, 2000.
Last month, Retire Early received quite a few questions on making "penalty free" withdrawals from your IRA before age 59 1/2 under the 72(t) exception. (See, "Can I withdrawal money from my IRA before age 59 1/2?") The most frequently asked questions are answered below.
Where can I find the UP-1984 Mortality Table that is mentioned in IRS Notice 89-25?
You can find the UP-1984 Mortality Table at the Society of Actuaries
website. See the instructions below. Go to the Society of Actuaries
website at http://www.soa.org/
Once you have the UP-1984 Mortality Table you still have to convert it into an annuity factor. This is a fairly complex calculation. Retire Early has developed an Excel spreadsheet that makes this calculation. You can download it free, click here.
How do I notify the IRS that I want to withdraw money from my IRA before age 59 1/2?
Your IRA Custodian will have a form for you to fill out when you make a distribution from your IRA. There will be a box for you to check with something like "Early (premature) distribution, IRS exception applies." Your Custodian then reports this to the IRS on Form 1099-R. You should also receive a a copy of Form 1099-R from your IRA Custodian.
When you file your Federal tax return you will have to include "IRS Form 8606 Non-deductible IRAs" to calculate the tax on the IRA distribution.
You don't have to actually tell the IRS which of the three IRS approved methods you use when you file your return, but you do have to show them your calculations if they audit you. Save all your paperwork.
I took my first "substantially equal periodic payment" (SEPP) last year. My IRA Custodian didn't put exception code "2" on the Form 1099-R it sent to the IRS and they refuse to correct the error. Am I now forced to pay the 10% penalty tax or is there some way to straighten this out?
You can file IRS Form 5329 to correct the error. You can download a
copy from the IRS website in .pdf format at the links below:
Once you get this straightened out, it's probably time to move your IRA to a different Custodian. You shouldn't have to put up with this kind of nonsense.
Do you have to use your IRA account balance from December 31st of the prior year or can you value your IRA on another date?
I've found the best discussion of this point in the Slesnick/Suttle book mentioned below. Here's the quote from page 4/12.
"Although the IRS has not prescribed the date as of which the account balance is to be determined, using the December 31 account balance is the most consistent with the overall guidelines. Note, however that some [private letter] rulings have allowed the use of account balances for the month before the first distribution, and others have allowed the use of account balances sometime during the same month as the first distribution. Although the sketchy guidelines offer no guarantees, it seems the IRS will approve account balances determined at any of those times."
It seems you can use other dates than December 31, but if you want to be 100% sure you'll survive an IRS audit, get your own private letter ruling. See the details below.
Do you have to make withdrawals from your entire IRA or can you use just part of it?
You must use the entire IRA balance in making the withdrawal
calculation. However, you are allowed to open a new IRA and transfer part
of your old IRA into the new IRA.
When I retire from my job and rollover my 401k into an IRA, can I break up the account into two IRAs?
You can split your 401k into two different rollover IRAs if your former employer agrees to cut 2 checks, one for each IRA custodian. If your former employer won't cut 2 checks, then you need to put it all in one rollover IRA. You can then subsequently rollover a portion of the IRA into a second rollover IRA at any time.
What's this I hear about being able to withdraw "company stock" from a 401k account and only pay taxes on the "cost basis?"
This is probably the the biggest mistake people make when they cash out their 401k account. You shouldn't automatically assume that rolling your 401k into an IRA is the best thing to do.
By taking possession of your company stock and paying ordinary income taxes on the "cost basis" of the stock, gains on subsequent sales of stock (i.e., the net unrealized appreciation (NUA)) will be taxed at the capital gains rate (max=20%). If you roll over the 401k account to an IRA, any sales of company stock would be taxed at the ordinary income rate (max=39.6%).
IRS Publication 575 - Pension and Annuity Income, Page 21, "Distributions of Employer Stock" details the application of this rule. Here's an excerpt:
"Distributions of employer securities. If your distribution includes securities in the employer's corporation, these securities may have increased in value while they were in the trust. "Securities" includes stocks, bonds, registered debentures, and debentures with interest coupons attached. This increase in value is called "net unrealized appreciation(NUA).""
Becoming familiar with this rule will save you a lot in taxes if you are fortunate enough to have highly appreciated company stock in your 401k account
Once you take possession of your company stock certificates, they're treated like any other stock that you own in a taxable account. There are no restrictions on how much or how little stock you can sell each year.
Note 1: This "company stock" rule only applies to your employer's stock. It does not apply to any other shares of stock or mutual funds that you hold in a 401k account.
Surprisingly, it also does not apply to a mutual fund that holds your company's stock. Even if that's the only stock in the fund.
Note 2: To take advantage of the "company stock" rule you must make a lump sum distribution of your entire 401(k) balance and any other "qualified" plans that you have with your employer. You can roll over the "non-company stock" portion of the lump sum distribution into an IRA if you don't need all the money right away.
I've heard there are some unusual estate planning pitfalls with "company stock." What are they?
IRS Revenue Ruling #75-125 states that the "net unrealized appreciation" NUA (at time of distribution) is "income in respect to the decedent," and is subject to the long term capital gains tax to the heirs, just like any other pension benefit not yet taxed to the deceased.
That's why the August 16, 1999 issue of Fortune, Page 120, had this to say regarding company stock in a 401(k):
"One consideration: If you never sell those shares, your hiers wind up owing capital gains on the appreciation going all the way to thier value when they originally came into your possession. That's a lot more than they'll owe on the other stock they inherit, which is only taxed on the appreciation since your death. If you have a choice, then, sell your company stock to meet retirement expenses and leave other assets to the kids."
Can I use an interest rate higher than "120% of the applicable Federal rate" to increase my IRA withdrawal?
You would need to get an IRS Private Letter Ruling to make sure that using a higher interest rate would survive an audit. The IRS charges a "user fee" (somewhere around $1,000) for each private letter ruling you request. (If your gross income is less than $150,000, the IRS cuts the user fee to $500 or $600 depending on the IRS Revenue Procedure that applies to your request.) A CPA or tax attorney would charge you another $1,000 or more to fill out the form requesting the ruling. (Nice work if you can get it.)
Internal Revenue Bulletin 1999-01 explains the step by step process for requesting a private letter ruling. You can read it on-line, click here.
Can I get together with a group of friends and apply for a private letter ruling as a group? If we split the $2,000 cost 10 ways, it would only be $200 a piece.
No. A private letter ruling for one person cannot be used by someone else. They have to get their own. That doesn't mean you can't use the information to file your return. You just can't point to the someone else's private letter ruling as a defense if you are audited.
You don't seem to like the amortization and annuity methods for younger retirees since these two methods result in a fixed payment until you reach age 59 1/2. Is there any way to recalculate my annual withdrawal if I use the annuity method and my IRA greatly increases in value?
A recent IRS private letter ruling allowed a former stock broker with an IRA that had grown to over $9 million to recalculate his distribution annually using the amortization method. (See, IRS Letter Ruling No. 199909059) The calculation method described in the letter ruling appears to address all of my concerns with using the amortization method if you are younger than age 45.
(Note: To avoid even the possibility of a problem with the IRS, I suggest you get your own private letter ruling before attempting to use the method described in Letter Ruling No 199909059.)
If we had a big stock market decline, there is a chance your IRA would be depleted before you reach age 59 1/2 when using the amortization or annuity methods. (This is because you don't recalculate your withdrawal based on the year end balance.) What's the penalty if there is no money left in your IRA before you complete your "substantially equal periodic payments (SEPP)?"
Interesting question. Nobody seems to know. I suspect the IRS position would be they'd want to assess the 10% penalty plus interest for all the previous annual distributions. (Talk about adding insult to injury!) Perhaps you could fight it in Tax Court and get the penalty reduced, but litigation costs money.
The best solution is to keep your annual withdrawal low as a percentage of assets. For example, a 45 year old would take SEPP distributions for 15 years. The Trinity study found that for a 75% stock/25% bonds portfolio an 8% annuity withdrawal (i.e., not inflation adjusted) has a 95% chance of success for a 15 year pay out period. That's a 5% chance you'll run out of money and incur IRS penalties. That's more than enough risk for me.
Are there any books or reference materials you can recommend on the subject of IRA early withdrawals?
You're in luck. Nolo Press publishes a popular book on the subject that's in its third edition.
Boy, this stuff is more complicated than I thought. How much would it cost to have a "tax advisor" make the IRA early withdrawal calculation for me?
A Big Six accounting firm (e.g., PriceWaterhouse, Ernst & Young, etc.) would charge a minimum of $600, more depending on how much time they spend. A small local accounting firm or a one man shop might make the calculation for $200 or less.
Whatever firm you use, get an "opinion letter" from the tax advisor explaining how the return was prepared, you will need this if you are audited. This opinion letter won't protect you from paying the 10% IRS penalty and interest charges if your tax preparer makes an error, but at least the IRS won't charge you with the higher penalties associated with filing a fradulent or negligent tax return if you had good reason to rely on the advice of your tax advisor.
If you use a smaller firm, make sure your tax advisor has adequate "errors and ommissions" (i.e., "malpractice") insurance. Don't take his word for it. Ask for the name of his malpractice insurance company and get a "binder" letter directly from the insurance company proving that the coverage is in force. Better yet, make sure your contract with your tax advisor explicity states that he will reimburse you for any IRS penalty or interest charges that arise from his advice. (Good luck in getting anyone to agree to this.) If you need to sue your tax preparer and recover your losses under his malpractice insurance policy, you'll need to hire a lawyer and it will likely take some time to settle the claim. The IRS will want its money immediately. It's likely you will recover your losses more quickly under contract language specifying your tax preparer is responsible for any IRS penalties.
Depending on the size of your IRA, you could easily be liable for tens of thousands of dollars of IRS penalties and interest if your tax advisor makes an error. If you're paying for this kind of advice, you want to ensure that the advisor will "keep you whole" if he screws up.
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Copyright © 2001 John P. Greaney, All rights reserved.