EXECUTIVE SUMMARY

WHEN CLIENTS ARE DESPERATE FOR FUNDS because of unforeseen circumstances, CPAs can help them tap retirement funds without triggering the 10% early withdrawal penalty. Eight exemptions to this penalty relate to life cycle events and present tax-planning opportunities. DISTRIBUTIONS TO A DISABLED TAXPAYER who has little or no disability insurance may escape the 10% penalty. A taxpayer with deductible medical expenses also may qualify for an exemption. A TAXPAYER WHO RETIRES BEFORE AGE 591/2 is exempt from the 10% penalty if the distribution is part of a series of substantially equal periodic payments. An employee who quits his or her job, however, must be at least age 55 to avoid the penalty. IRA DISTRIBUTIONS WILL NOT BE PENALIZED if the funds are used to pay health insurance premiums for an unemployed taxpayer and his or her family, qualified higher education expenses for his or her family, or a first-time home purchase. A DISTRIBUTION MADE UNDER a bona fide loan agreement may escape the penalty. CPAs WITH CLIENTS WHO QUALIFY for more than one exemption must determine the mix of exemptions that will meet their financial needs.

LEE G. KNIGHT, PhD, is the Hylton Professor of Accountancy and director of the accountancy program at the Calloway School of Business and Accountancy, Wake Forest University, Winston-Salem, N.C. Her e-mail address is knightlg@wfu.edu. RAY A. KNIGHT, CPA/PFS, JD, is managing director of Capstone Planning Alliance, LLC, in Winston-Salem. His e-mail address is rayknight@capstoneplanning.net.

PAs commonly advise clients not to touch their savings in IRAs and employer-sponsored retirement plans before age 59¹/2 because of tax disincentives; in addition to ordinary income taxes, IRC section 72(t) imposes a 10% penalty on early withdrawals. But if clients desperately need funds to handle unforeseen life cycle events, CPAs must abandon their normal position and seek ways to minimize the related tax disincentives. IRC section 72(t) provides for 16 exemptions from the early withdrawal penalty (see exhibit 1), eight of which relate to life cycle crises. This article discusses the applicability and restrictions associated with these eight exemptions and provides CPAs with guidance on how clients can qualify for them.

GENERAL APPLICABILITY OF THE PENALTY
The 10% penalty is an income tax rather than an excise tax. It applies to any early distribution includable in the recipient’s gross income from a qualified retirement plan, defined in IRC section 4974(c) to include

Section 401(a) qualified pension, profit-sharing or stock bonus plans.
Section 403(a) annuity plans.
Section 403(b) tax-sheltered annuity contracts.
Section 408(a) individual retirement accounts (IRAs).
Section 408(b) individual retirement annuities.

An early distribution is one made before the participant reaches age 59¹/2 . The penalty does not apply to the portion of an early distribution that is a return of basis, nor to any of the distributions identified in exhibit 1.

DISTRIBUTION FOLLOWING A DISABILITY
The 10% penalty doesn’t apply to a distribution made to a disabled participant. IRC section 72(m)(7) and related regulations define a participant as disabled if he or she cannot engage in any “substantial gainful activity” because of a medically determined physical or mental impairment expected to result in death or to be of long-continued or indefinite duration, and can furnish proof of this condition in the form or manner required by the IRS.

“Substantial gainful activity” refers to the activity in which the participant normally engaged or a comparable one before the disability. Treasury regulations section 1.72-17(A)(f)(2) provides examples of impairments that ordinarily prevent people from engaging in a substantial gainful activity (see exhibit 2). However, having one or more of these impairments doesn’t always permit a finding that an individual is disabled. The IRS evaluates the impairment based on whether it in fact prevents the person from engaging in substantial gainful activity.

An impairment is “of indefinite duration” if the participant cannot reasonably be expected to recover in the foreseeable future (Treasury regulations section 1.72-17A(f)(3)). For example, participants who suffer bone fractures that prevent them from working are not disabled if recovery is reasonably expected in the foreseeable future. If a bone persistently fails to knit, however, the IRS ordinarily will consider the individual disabled.

Clients don’t normally expect or plan for a disabling accident, and the few who purchase disability insurance often do not have adequate funds to sustain them during the required waiting period until disability payments begin. CPAs should counsel clients of the availability of retirement funds for this purpose.

DISTRIBUTION OF SUBSTANTIALLY EQUAL PERIODIC PAYMENTS
The 10% penalty does not apply to a distribution of plan assets that is part of a series of substantially equal periodic payments, paid not less frequently than annually, for the recipient’s life (or life expectancy) or the joint lives (or joint life expectancies) of the recipient and a designated beneficiary. Distributions from a qualified plan other than an IRA or individual retirement annuity qualify for this exception only if they begin after the employee separates from the employer’s service (IRC section 72(t)(3)(B)).

In notice 89-5, the IRS presents three methods of calculating distributions from a defined contribution plan or an IRA that will satisfy the substantially equal requirement.

Required minimum distribution method (sanctioned under IRC section 401(c)(9)). In calculating the annual payments, participants may use either their own life expectancy or the joint life and last survivor expectancy of the participant and a beneficiary. Revenue ruling 2002-62 modifies notice 89-5 to require participants to calculate these payments annually, using the account balance and the appropriate life expectancy table at the beginning of each year they receive payments. This requirement produces unequal payments, but the IRS treats them as a series of substantially equal payments provided the participant does not change to another method of calculation.

Fixed amortization method. Participants determine the annual payment by amortizing the account balance over their life expectancy or the joint life and last survivor expectancy for the participant and a designated beneficiary.

Participants must determine the life expectancies for this purpose in accordance with regulations section 1.401(a)(9)-1. The interest rate cannot exceed a reasonable rate on the date payments begin. Unlike the minimum distribution method, the payments under the fixed amortization method are the same for all years.

For example, let’s assume a 50-year-old participant decides to withdraw an IRA balance of $100,000 in installments. His life expectancy in table V of regulations section 1.401(a)(9)-1 is 33.1 years. In the year in which payments begin, 8% is a reasonable interest rate. Amortizing $100,000 over 33.1 years at an 8% interest rate yields a payment of $8,679.

Fixed annuitization method. Participants determine their annual payment by dividing the account balance by an annuity factor for the present value of $1 per year (or per month if monthly payments are made), assuming a reasonable interest rate at the time the payments begin and a time period equal to their life expectancy at their age in the first distribution year (using a reasonable mortality table).

As with the fixed amortization, the payments remain the same for years subsequent to the first distribution year. Our 50-year-old participant with an account balance of $100,000 would have substantially equal payments of $9,002 a year, assuming an 8% interest rate ($100,000 4 11.109, the annuity factor for a $1 per year annuity using the UP-1984 mortality table).

Note that the IRS did not intend to limit taxpayers to these three methods presented in notice 89-25 (letter rulings 9008073 and 9615042). Any reasonable method of calculation satisfies the requirements of IRC section 72(t)(2)(A)(iv) (letter ruling 8921098).

Guidelines for all methods. Revenue ruling 2002-62 provides that the interest rate used in calculating the annual payments cannot exceed 120% of the federal midterm rate determined under IRC section 1274(d) for either of the two months immediately preceding the month the payments begin. The IRS places no lower limit on the interest rate, which can work in favor of clients who want to minimize the amount they take each year.

Revenue ruling 2002-62 also stipulates that taxpayers must use the account balance as of the first valuation date selected for this purpose. Any subsequent change in the balance results in a modification of payments.

Any modification in payments before the participant reaches age 59¹/2, or within five years of the date of the first payment (even if the participant has reached age 59¹/2), other than because of the participant’s death or disability, voids the periodic payment exception. In the year of modification, any tax not paid because of the periodic payment exception, plus interest for the deferral period, becomes payable.

For example, John Kelly, a 56-year-old participant in a defined contribution plan, began receiving substantially equal periodic payments in 2000 that he expected to continue for the rest of his life. But in 2004, at age 60, Kelly elected to receive the remaining benefits in a lump sum. Because this modification took place within five years of the date of the first payment, he must pay the 10% additional income tax plus interest on the payments received before he reached age 59¹/2 (but not on the payments received after age 59¹/2).

Kelly’s CPA could have suggested he avoid the recapture tax by not taking the lump-sum payment until 2005. CPAs with clients who want to receive payments from IRAs or qualified plans before age 59¹/2, and do not qualify for one of the other exceptions, should point out the perils of modifying distribution payments and show clients how to structure their payments to avoid the recapture tax.

A series of rulings shows the IRS does not consider all changes in periodic payments as modifications that trigger the recapture tax. Exhibit 3 summarizes some of these rulings to give CPAs an idea of how difficult it is to advise clients in this area without careful research. Many of the changes the IRS lets escape the recapture tax differ little from those it considers modifications, and thus, taxable.

DISTRIBUTION DUE TO SEPARATION FROM SERVICE
Early distributions from a qualified plan are exempt from the 10% penalty IRC section’s 72(t)(2)(A)(v) if the participant leaves the employer maintaining the plan during or after the calendar year in which he or she attains age 55. This exemption does not apply to self-employed people or distributions from IRAs.

CPAs may find this exemption beneficial to clients who quit their jobs to follow a spouse transferred temporarily or permanently to a new location. They can tap their retirement funds while they search for a new job. Be aware, however, that the IRS is likely to scrutinize any short separation to determine whether it is a bona fide indefinite separation from service.

DISTRIBUTION FOR MEDICAL EXPENSES
The early withdrawal penalty does not apply when a qualified retirement plan distribution is less than or equal to a participant’s deductible medical expenses for the tax year of distribution (IRC sections 72(t)(2)(B) and (3)(A)). CPAs should discuss this option with any clients facing large medical bills at a time when they have been laid off from their jobs and cannot afford health insurance.

Taxpayers may deduct any medical expenses in excess of 7.5% of their adjusted gross income (AGI) under IRC section 213. They do not have to itemize the deductions to qualify for this exemption (IRC section 72(t)(2)(B)).

As an example, Matt Gear withdrew $6,500 from a qualified retirement plan to help cover $8,000 in medical expenses he incurred during 2004. Gear’s AGI for 2004 was $48,000. Under section 213 he can deduct only $4,400 of his medical expenses (the portion in excess of his medical expense deduction floor, 7.5% of his $48,000 AGI, or $3,600. $8,000 – $3,600 = $4,400). Even if Gear does not itemize deductions in 2004, $4,400 of the amount he withdrew from his retirement plan will escape the section 72(t) penalty, though he will have to pay the 10% penalty on the remaining $2,100 ($6,500 – $4,400).

CPAs should advise clients who can push medical procedures into a tax year that has a more favorable AGI to do so, so that more of their withdrawal will escape the section 72(t) penalty. CPAs also can help clients combine the medical expense exemption with other exemptions so the penalty does not apply to any of the withdrawal.

DISTRIBUTION FOR HEALTH INSURANCE PREMIUMS
Section 72(t)(2)(D) exempts IRA distributions for health insurance premiums paid for unemployed account holders, their spouses and dependents from the early withdrawal penalty if

The account holder receives federal or state unemployment compensation for at least 12 consecutive weeks.

The distribution occurs during the tax year the holder receives the unemployment compensation or the following tax year.

The exemption covers distributions only up to the amount of premiums paid or distributions made until the account holder is re-employed for at least 60 days.

CPAs should point out to clients that this exemption doesn’t require them to actually use the money from the distribution to pay the premiums. Also, self-employed clients qualify for this exemption if self-employment is the only reason they do not qualify for unemployment compensation.

DISTRIBUTIONS FOR HIGHER EDUCATION EXPENSES
The penalty does not apply if IRA distributions are used to pay qualified higher education expenses (QHEEs) of the account holder or a spouse, child or grandchild at an eligible institution. If a distribution qualifies for one of the section 72(t) exemptions discussed above, however, the account holder cannot apply the higher education expense exemption (section 72(t)(2)(E)).

As defined in section 529(e)(3), QHEEs include tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. Almost all accredited colleges, universities and vocational schools fit this description. Students can pay with their earnings, a loan, a gift, an inheritance or personal savings.

Expenses paid with a Pell Grant or other tax-free educational assistance reduce the amount of the IRA distribution escaping the 10% penalty. Thus, CPAs should determine the types of educational assistance for postsecondary education that clients already receive before advising them of the amount that can be withdrawn without penalty.

For example, Susan Bennett’s QHEEs total $35,000 for the 2004–2005 academic year. Her parents pay $30,000 of these costs from a combination of earnings, loans, personal savings and savings from a qualified state tuition program; Bennett pays the remaining $5,000 from gifts, inheritances and her own earnings. Her father, age 51, can withdraw $35,000 from his IRA without incurring the 10% early withdrawal penalty.

In contrast, Don Mason’s QHEEs total $35,000. His family uses a combination of a Pell Grant, a tax-free scholarship and tax-free employer-provided tuition assistance to pay $30,000. His father, age 51, can shield only $5,000 of the amount he withdraws from his IRA from the penalty.

DISTRIBUTION FOR FIRST-TIME HOME PURCHASE
The 10% penalty doesn’t apply to a “qualified first-time homebuyer distribution” from an IRA (section 72(t)(2)(F)) if the distribution is used within 120 days of its receipt to pay qualified acquisition costs associated with the first-time purchase of a principal residence. The homebuyer may be the IRA holder or spouse, child, grandchild or ancestor (section 72(t)(8)(A)). The term principal residence means the same as it does for calculating the excludability of gain on sale under section 121 (section 72(t)(8)(ii)).

Section 72(t)(8)(C) defines qualified acquisition costs to include the expenses of acquiring, constructing or reconstructing a residence, as well as any usual or reasonable settlement, financing or other closing payments.

CPAs should note that the term first-time homebuyer is a misnomer in that it does not preclude previous home ownership. Instead, it holds that the homebuyer (and spouse, if married) cannot have had an ownership interest in a principal residence during the two-year period ending on the date of acquisition (section 72(t)(8)(D)(i)(I)).

A lifetime limit of $10,000 applies to the first-time homebuyer exemption (section 72(t)(8)(B)). Buyers also cannot use this exemption if the IRA distribution qualifies for one of the other section 72(t) exemptions.

For example, Lisa and David Jones sold their principal residence and moved into a rental home in 1999. In 2005 Lisa withdrew $10,000 from her IRA to use as a down payment on the purchase of a new home. Lisa and David must include the withdrawal in their gross income, but do not have to pay the penalty.

CPAs should carefully counsel clients who plan to use IRA money for a home acquisition about the time limits involved. Clients must use the money within 120 days of the date of withdrawal. If the purchase is delayed or canceled, clients must roll the distribution into an IRA within the 120-day period to avoid the penalty. And clients who sell one home must wait at least two years before buying a new one to qualify.

DISTRIBUTION SUBJECT TO LOAN AGREEMENT
IRC section 72(p) excludes distributions made under a loan agreement from the early withdrawal penalty if the loan agreement is legally enforceable and imposes restrictions on the term, repayment and amount of the loan. The agreement may be on paper, electronic or in any other medium approved by the IRS. A signature is not required if the pact is enforceable without signature under applicable law (regulations section 1.72(p)-1, A-3(b)).

The term of the loan generally cannot exceed five years, unless the loan is used to acquire a dwelling unit that will be the participant’s principal residence within a reasonable period of time. If it exceeds the term limits (either initially or later because of nonpayment), the 10% penalty applies on the entire loan (regulations section 1.72(p)-1, A-4).

The loan agreement must specify a repayment schedule. The agreement may provide for a three-month grace period, and section 414(u)(4) allows a participant to suspend payments during military service. Otherwise, if participants fail to pay an amount due, the IRS will treat the entire loan as a distribution subject to the 10% penalty (regulations section 1.72(p)-1, A-3(b)).

Section 72(p)(2)(A) stipulates that the amount of the loan plus all other loans from the same employer generally cannot exceed the lesser of $50,000 or half of the present value of the employee’s nonforfeitable accrued benefit under his or her retirement plans.

Coordinating section 72(t) exemptions requires a little thought and creativity, but CPAs can maximize their value by providing this financial lifeline to clients who are facing layoffs, forced early retirements or other catastrophes.