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Switch your early annuity distributions in midstream

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Is most of your money tied up in investments? You're certainly not alone. But that may create a cash crunch if you need funds in a hurry for an emergency or an unexpected expense.

Strategy: Tap into an annuity if you need cash in a pinch. Under the tax rules for annuity distributions, only a portion of the payout is taxable while the remainder is treated as a tax-free return of capital. The taxable portion is figured under the "exclusion ratio" for annuity distributions.

But yet another obstacle exists for some taxpayers. If you're under age 59 1/2 when you withdraw the funds, you're stuck with paying a 10 percent penalty, unless you qualify for a "special exception." That's the same rule that restricts early withdrawals from tax-deferred retirement accounts, such as IRAs. But now the IRS has tinkered with the rules to provide annuity owners greater flexibility. (IRS Notice 2004-15)

Avoiding the 10 percent penalty

How it works: One of those "special exceptions" for pre-age 59 1/2 withdrawals says you don't have to pay the 10 percent penalty if you receive the money in a series of "substantially equal periodic payments" based on your life expectancy (or the joint life expectancy of you and a designated beneficiary).

But tax law says the 10 percent penalty will still be triggered if you "substantially modify" the payments within five years or before reaching age 591/2, whichever comes later.

The IRS has approved three different methods of determining the amount of these annual payments: required minimum distributions (RMDs), the fixed amortization method, and the fixed annuitization method. (See box at right for details on each.)

The RMD method is the simplest method and tends to provide the smallest annual payout, while the other two methods generally provide larger payouts.

Here's the catch: Once you begin withdrawing a series of substantially equal periodic payments, you must continue doing so for at least five years. Because of the extreme volatility in economic markets, that could create problems for annuity investors. In the worst-case scenario, it can even deplete the annuity funds just to satisfy the annual distribution requirement.

IRS allows one-time switch

What's new? If you've already started payments, the IRS now says you can make a one-time change to the RMD method without triggering the 10 percent penalty for early withdrawals.

That should help alleviate concerns of annuity holders over market fluctuations. These IRS changes mirror previous revisions in the rules for early retirement-account distributions. (IRS Revenue Ruling 2002-62)

Final note: There's no such thing as a free lunch. If you make an early withdrawal from an annuity, you may owe surrender charges on top of any income tax liability. Remember to use this strategy only when the situation clearly calls for it.

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