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Early IRA withdrawals: Sidestep a tax pitfall

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in Small Business Tax

Do you need to “raid” your IRA to pay unexpected expenses? If you’re under the age limit, the IRS will generally penalize you for making an early withdrawal before age 59 1/2.

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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