The Internal Revenue Service recently ruled that an improper transfer of funds from an individual retirement account from which the client was taking 72(t) payments triggered the 10% early-withdrawal penalty.
In an IRS Private Letter Ruling (PLR 200925044), the agency ruled that in attempting to change the IRA investments, the client had modified the 72(t) payment schedule. With so many clients changing investments or custodians these days, financial advisers have to be aware of the special rules that apply when a client takes a series of early withdrawals from an IRA.
This wasn't the first time that the IRS had ruled that a modification occurred when the account balance in an IRA subject to a 72(t) payment schedule was changed when the funds were moved to another IRA. The modification resulted in retroactive penalties and interest.
Taking a series of substantially equal periodic payments (72(t) payments) from an IRA can be an effective planning strategy in cases where the client needs additional income and has no other non-IRA funds that can be tapped.
Although 72(t) payments don't excuse taxpayers from the income tax liability on distributions, they can help to avoid the 10% early distribution penalty on withdrawals taken before age 591/2. They must continue for five years or until the owner reaches age 591/2, whichever period is longer.
Failure to maintain the schedule for the required time period, including changes to the account balance through additions or subtractions other than earnings and losses, will result in a “modification” of the schedule.
When a modification occurs, the 10% penalty for premature distributions is applied retroactively, plus interest, to all 72(t) payments re-ceived before age 591/2.
Here are the facts of the case.
A taxpayer, “Sue,” had two IRAs with Company X.
In 2002, she began taking 72(t) payments from what we'll call IRA 1, using the amortization method permitted under IRS rules. For the next six years, Sue continued her payment schedule, taking out the same annual payment each year.
In January of the first year, Sue became concerned about market conditions and met with her adviser to discuss moving a portion of her IRA investments to cash.
During the meeting, her adviser explained that though Company X offered a cash investment option and that she could effect this change without incurring a penalty, it wasn't a certificate of deposit. Sue's adviser subsequently recommended moving a portion of her IRA to another institution that offered such investments.
Taking this advice, she transferred a portion of IRA 1's balance, along with the total balance from IRA 2, which wasn't subject to any 72(t) payment schedule, to a new IRA at an institution that offered CDs. Both accounts were moved via trustee-to-trustee transfers.
In May of the same year, after speaking with representatives from the new institution about transferring the remaining balance in IRA 1 to them as well, Sue learned that her initial transfer caused a modification of her 72(t) payments.
When Sue approached her adviser about the issue, he not only confirmed that the transfer was a modification of the 72(t) schedule, but also informed her that she was subject to the 10% penalty for early distributions and interest.
In an attempt to rectify the situation, Sue submitted a request for a private letter ruling to the IRS, in which she explained her situation and the potential “corrective” steps she wished to take.
Sue requested that the partial transfer of the IRA funds subject to the 72(t) payment schedule not be considered a modification of the 72(t) payment schedule. In addition, she requested that a “corrective” transfer of the funds back to the original IRA be permitted to correct the error.
Though she had received questionable advice from her financial adviser and had the foresight to try and take “corrective” action (often a key aspect of a favorable ruling), the IRS denied both of Sue's requests.
In this case, the client — who obviously needed money — paid additional penalties and interest due to the error, and also had to pay a $9,000 fee for the ruling request. She also probably incurred thousands of dollars of additional professional and legal fees.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
