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Retirement Benefits Planning Update
Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.
Reaching Plan and IRA Benefits Before Age 59 1/ 2
Rev. Rul. 2002–62, 2002–42 I.R.B. 1, modifies and replaces Notice 89–25, Q&A 12, 1989–1 C.B. 662, the notice that has provided guidance as to which distributions from an Individual Retirement Account (IRA) or qualified plan constitute a part of a series of substantially equal periodic payments within the meaning of the Code § 72(t)(2)(A)(iv) exception to the 10% tax on premature distributions that may otherwise be imposed on a plan participant or IRA account owner who has not attained age 59 1/ 2.
A plan participant who has separated from service or an IRA account owner (hereafter “participant”) who wishes to receive distributions before attaining age 59 1/ 2 may do so without having to pay a premature distributions penalty tax equal to 10% of the amount of the distribution includable in the participant’s income if the distributions received are part of a series of substantially equal periodic payments (hereafter “equal payments”) made at least annually for the life (or life expectancy) of the participant or the joint lives (or life expectancies) of the participant and his designated beneficiary within the meaning of Code § 72(t)(2). If the equal payments are modified (other than by reason of death or disability) before the end of the “payment period”—the period beginning with the date of the first payment and ending on the date on which the participant attains age 59 1/ 2 or on the fifth anniversary of the initial payment, if later—the 10% tax is retroactively recaptured with interest for each distribution received under the exception. Code § 72(t)(4). Thus, although the payments are measured by the participant’s life expectancy, the payments may be discontinued or modified after the end of the payment period without penalty.
Notice 89–25 described three methods of payment, each of whichconstituted a series of equal payments within the meaning of Code§ 72(t)(4)(iv)—the minimum required distribution (MRD) method, the fixed amortization method, and the fixed annuitization method. Over 100 private letter rulings were issued subsequent to the publication of the notice, many to confirm that a proposed series of equal payments satisfied the parameters of Notice 89–25, particularly the requirement that a “reasonable interest rate” had been used in determining fixed amortization payments or fixed annuity payments or the requirement that the annuity factor used to determine fixed annuity payments had been derived from a “reasonable mortality table.” Rev. Rul. 2002–62 modifies Notice 89–25 for equal payments made after 2002 in light of the revisions made to the MRD rules by the final regulations under Code § 401(a)(9), which were published on April 17, 2002. 67 Fed. Reg. 18,988. Rev. Rul. 2002–62 also provides an exception to the rule that equal payments may not be modified and provides more specific (if less flexible) rules for the three safe harbor methods of payment.
New Safe Harbors
Unlike the fixed amortization and annuity payment alternatives, the MRD method of payment produces a series of payments that may vary in amount because of the IRA or plan account investment results and because of the increase in the divisor used to determine each annual payment as the participant (and beneficiary, if any) ages. The participant may cause the payments to vary by changing the designated beneficiary if the joint and survivor life expectancy table is used and, to a lesser extent, by selecting the date within each year as of which the account will be valued for purposes of determining each annual distribution. Under Section 2 of Rev. Rul. 2002–62, an employee may select any of the three life expectancy tables published in the final MRD regulations (the uniform lifetime table, the single life table, and the joint and last survivor table) to apply to distributions commencing in 2003 (Appendix A to the ruling extends the uniform lifetime table, which begins at age 70 in the MRD regulations, to include ages 10 through 69). See Treas. Reg. § 1.401(a)(9)-9, Q&A 1 (single life table) and Q&A 3 (joint and last survivor table). Once selected, the same table must be used in all distribution years within the payment period. If the joint life table is selected, the beneficiary must be the participant’s designated beneficiary for the account on January 1 of the year of distribution, as determined for purposes of Code § 401(a)(9). Rev. Rul. 2002–62, § 2.02(a) and (b).
In the case of the fixed amortization method, the annual payment for each year is determined in the same manner as a reverse mortgage by amortizing the account balance at the time of the initial payment in level amounts over the number of years shown on the selected life expectancy table (uniform, single life, or joint and survivor) using a selected interest rate. Any interest rate that is not more than 120% of the federal mid-term rate determined in accordance with Code§ 1274(d) for either of the two months preceding the month in which distributions begin may be selected. Rev. Rul. 2002–62, § 2.02(c). Once the annual distribution amount for the first distribution year is determined, the annual payment is the same amount in each succeeding year.
To determine the annual payment under the fixed annuitization method, the account balance at the time of the initial distribution is divided by an annuity factor for the present value of an annuity continuing for the life of the participant (or the lives of the participant and the designated beneficiary) derived using the table in Appendix B to Rev. Rul. 2002–62 and using a selected interest rate no higher than the Section 1274(d) rate. Once determined for the initial distribution year, the annual payment is the same amount in each succeeding year. Rev. Rul. 2002–62, § 1.01(c).
One Time Shift to MRD Method
A participant who has begun to receive equal payments under either the fixed amortization method or the fixed annuitization method (in which the annual payment is not correlated with the account’s changing balance) may, in any subsequent year, switch to the MRD method to determine the payment for the year of switch and all future years without having the change of method be considered to be a modification of equal payments resulting in the imposition of the recapture tax. Rev. Rul. 2003–62, § 2.03(b). This escape valve was adopted because a decline in stock values places risks of depletion on accounts from which fixed payments are required. For equal payments that commenced before 2003 under the amortization or annuity methods, the switch to the MRD method may include the selection of a different life expectancy table. Rev. Rul. 2003–62,§ 3. Permitting the use of a different life expectancy table allows participants whose payments commenced before the issuance of the final MRD regulations (and the updated life expectancy tables based on year 2000 mortality factors) to reduce the level of distributions from the level that would be required if the life expectancy tables in effect at the time of the commencement of distributions were required to apply to the MRD method. The permission appears sufficiently broad to permit a participant to change the kind of table (from single life or joint to uniform, single life, or joint) as well. Whether a different kind of table from the life expectancy table used to determine an initial amortization or annuity payment begun in or after 2003 can be selected on a switch to the MRD method in a subsequent year is not clear.
If no switch is made and an account is, in fact, depleted before the expiration of the payment period, the cessation of payments will not be treated as a modification or failure to make equal payments causing additional income tax under Code§ 72(t)(1). Rev. Rul. 2003–62, § 3.03(a).
In the case of equal payments made from an IRA, the participant’s objective of receiving a target distribution amount for each year of the distribution period to meet a financial objective can be accomplished under the more precise safe harbors by creating an IRA (via rollover from a larger IRA) with an initial balance that, when the selected safe harbor is applied, will produce the target annual payment amount. In contrast to the rule that requires the aggregation of all of an individual’s IRAs in determining the MRD amount that must be distributed, equal payments may be made from one or more IRAs used to calculate the equal payments for purposes of meeting the Code § 72(t)(2) exception without having to make similar payments from other IRAs maintained by the participant. PLRs 8946045, 92413054, 9525062, and 9816028. A separate account, or accounts, is required because the use of a portion of an IRA to determine the distribution is not permitted. PLR 9705033. The creation of a separate IRA as the source of the equal payments reduces the importance of the variables of life expectancy assumptions and interest rates because the initial balance of the IRA account can be adjusted to produce the desired objective and the nonparticipating IRA or IRAs need not be restricted as to distributions or designated beneficiaries.
Once the account balance from which the equal payments are to be made is identified, any addition to the account (other than investment gains), any nontaxable transfer of a portion of the account to another retirement plan, or any rollover of any of the equal payments received by the participant is a modification. Rev. Rul. 2002–62, § 2.02(e). Although broadly worded, it is unlikely that the foregoing prohibition is intended to prevent the split of an IRA in the case of a divorce that has been held not to be a modification even though the account balance and equal payments are reduced. PLR 200202074.
Outside the Harbors
A number of private letter rulings demonstrate that the methods of distribution described in Notice 89–25 were viewed as safe harbor alternatives to satisfy the equal payments requirement rather than as the exclusive alternatives to satisfy Code§ 72(t)(2). PLRs 9008073 and 9615042. Because Rev. Rul. 2002–62 modifies and replaces Notice 89–25, the extent to which the new safe harbors will be subject to modification will be unclear until a new series of private letter rulings or further guidance is issued.
It seems likely that private letter rulings that have approved life expectancy assumptions based on a variety of sources (including single sex based mortality tables) as being reasonable assumptions under Notice 89–25 will not be issued in the future. Similarly, the practice of applying a variable interest rate to vary periodic payments is contrary to the safe harbor requirement that amortized or annuity payments be made based on initially determined factors in the same amount for each year of the payment period. PLRs 2000105066 and 2000510052. Nevertheless, some variations in the three safe harbor methods may be permitted. The General Explanation of the Tax Reform Act of 1986 (the 1986 Act Blue Book) states that a series of payments will not fail to be substantially equal because the payments vary because of certain cost of living adjustments (page 717). A built-in 3% increase for cost of living was approved in Private Letter Ruling 9536031, and annual CPI increases were approved in Private Letter Ruling 200033048. j