Guest Article

(From the August 31, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Transfer of Partial Account Balance Subjects Periodic Payments to 10% Penalty

A recent IRS ruling illustrates the rigidity of the rules under IRC § 72(t) by which "substantially equal periodic payments" are exempt from the 10 percent early distribution tax. An individual's non-taxable transfer of a portion of her individual retirement account to another IRA constituted a prohibited "modification" of the payments, which the IRS ruled could not be corrected by reversing the transfer. The error resulted in the distributions she had taken over the prior seven years being retroactively subject to the 10 percent early distribution tax and interest. PLR 200925044 (March 23, 2009).

Transfer of Only a Portion of the IRA Caused a Modification

In 2008, an individual taxpayer submitted a request to the IRS for a private letter ruling after learning that her non-taxable transfer earlier that year of a portion of her individual retirement account (IRA) resulted in a prohibited "modification" of the "substantially equal periodic payments" she had been taking from that IRA since 2002. The taxpayer had completed the transfer on the advice of a financial advisor who suggested she invest a portion of the IRA in certificates of deposit, which were not available at the current financial institution, but which were available for IRAs at another institution. After opening an IRA at the other institution, the taxpayer transferred a portion of her original IRA. Later the same year, the taxpayer consulted with representatives of a third financial institution about the possible transfer of the remaining IRA assets and was informed that the prior transfer constituted a "modification" of her series of substantially equal periodic payments. In later speaking with her financial advisor she was told that the transfer would cause the imposition of the 10 percent early distribution tax, plus interest, on all amounts that had been distributed from the IRA since 2002.

Early Distribution Penalty Applies Retroactively

The taxpayer was age 56, and had begun taking substantially equal periodic payments from the IRA six years earlier, in 2002. IRC 72(t)(1) imposes a 10 percent tax on early distributions from qualified plans and IRAs. However, the tax is not imposed if the distributions are part of a series of "substantially equal periodic payments" that are made at least annually over the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and beneficiary. But, if the payments are modified (other than by reason of death or disability) before the individual reaches age 59-1/2, or after the individual reaches age 59-1/2 but before the close of the 5-year period beginning with the first payment, then the taxpayer is obligated to pay the 10 percent early distribution tax that would have been imposed on the earlier payments, plus interest.

"Substantially equal periodic payments" are calculated by reference to the account balance as of the first valuation date selected. Therefore, as the IRS explained in the letter ruling, a modification occurs if there is any (1) addition to the account balance other than gains or losses, (2) nontaxable transfer of a portion of the account balance to another retirement plan or IRA, or (3) rollover of the amount received so that it results in the distribution not being taxable.

Error Cannot Be Corrected by Reversing the Transfer

As a result, despite the fact that the transfer was made on the basis of erroneous advice from her financial advisor, and the taxpayer had proposed to correct the error by transferring the amount back to the original IRA, the IRS ruled that a "modification" had occurred and could not be corrected by undoing the transfer. Since the modification occurred in 2008, before the taxpayer reached age 59-1/2, she was obligated for that year to pay an additional 10 percent early distribution tax on the distributions she had taken from the IRA since 2002, plus interest.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955. Copyright 2009, Deloitte.