Strategy: Arrange to receive “substantially equal periodic payments” (SEPPs) from the IRA. If you handle things right, the IRS exempts SEPPs from the usual 10% penalty, no matter what your age.
But, as a new private letter ruling shows, as light misstep could cause you to forfeit the exemption. (IRS LR 200720023)
Here’s the whole story: Normally, you must pay a 10% penalty tax if you begin taking withdrawals from an IRA prior to age 59 1/2. The penalty is added on top of the regular income tax you owe. But you’re exempt from the penalty tax if you receive a series of “substantially equal periodic payments” (SEPPs) for at least five years or until you reach age 59 1/2, whichever is later. The IRS bases the payment amounts on your life expectancy (or the joint life expectancy of yourself and a designated beneficiary).
The IRS has identified three basic methods for calculating SEPPs. However, if you substantially modify the payment methods before age 59 1/2 (or five years, if that’s later), the IRS imposes a 10% penalty tax on all the payments.
New ruling: A taxpayer under age 59 1/2 started receiving SEPPs from an IRA in 1999 under the fixed annuitization method. Later that same year,the taxpayer transferred an amount from the IRA to a different IRA under a trustee-to-trustee rollover. A similar transfer occurred in 2000.
The IRS treats a rollover as a substantial modification even though it’s tax-free. Therefore, the taxpayer retroactively owes tax on all the SEPPs dating back to 1999.
Note: This easily could have been avoided if the taxpayer had just waited a few more years to roll over funds.
Tip: The exception for SEPPs applies separately for each IRA.
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