Required Min

· LERO

· Pre-LERO/72(t)

When would a 50% tax penalty be imposed?

An individual cannot defer funds in a qualified retirement account indefinitely (other than Roth IRAs). At some point the funds must begin to be distributed, and taxes must be paid on the amounts received. The IRS has specified that all owners of qualified retirement plans such as IRAs (other than Roth IRAs), 403(b)s, 457s, etc., must begin receiving required minimum distributions no later than April 1st of the year following the year in which the owner attains age 70 ½ — even if he or she is not retired. This is known as the required beginning date. For every year after the 70-½ year, the required minimum distribution must be made by December 31st.

For example, a woman born on February 26, 1932, would reach age 70 on February 26, 2002. This means she would be age 70 ½ on August 26, 2002 — which is exactly six months later. For tax year 2002 (her 70 ½ year), this woman must receive the required minimum distribution by April 1, 2003. She must also receive the required minimum distribution for 2003 by December 31, 2003. (This means that if this individual does not receive her required minimum distribution for 2002 until 2003, she will have to pay taxes on both the 2002 and 2003 distributions in the year 2003.) If, however, no distribution is taken or if the distribution is not large enough (as determined by using an age-based IRS distribution table), the IRS imposes a tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeds the actual amount distributed. For example, consider an individual who has received a total of $25,000 in annuity payments from his qualified retirement plan this year. According to the IRS distribution table, however, he or she should have received no less than $35,000 — which exceeds his actual distribution by $10,000. Consequently, the tax imposed by the IRS is $5,000.

How can the 50% tax penalty be avoided?

Simply speaking, the 50% tax penalty can easily be avoided by beginning the required minimum distributions by the required beginning date and in the required amounts. According to the Internal Revenue Code, a participant’s retirement funds must be distributed over his or her life or over the joint lives of the participant and his or her designated beneficiary.

This used to mean that those owners whose retirement accounts were housed in fixed annuities had to annuitize their contracts. Fortunately, as an alternative to annuitization, many deferred annuity contracts now offer a retirement income option called Life Expectancy Retirement Option or LERO. LERO can provide the owner with an annual retirement income guaranteed to meet the required minimum distribution requirements set by the IRS. These distributions are based on the owner’s life expectancy, according to the IRS tables, with regulations allowing the owner’s life expectancy to be recalculated each year or reduced by one each year, starting when the initial distribution is received. Once a life expectancy option is chosen it cannot be changed.

Furthermore, because all LERO distributions are made under the withdrawal provision of the annuity contract, LERO is not a formal settlement option. This means the owner continues to benefit from interest earnings and other annuity benefits, as well as maintains control of the funds. In short, by using LERO, an individual is able to satisfy the IRS requirements and avoid the 50% tax penalty, all without giving up any of the benefits he or she enjoys with his or her fixed annuity retirement account.

In addition, for individuals who do not need this additional income and who would like to share their funds with their heirs, new IRS changes allow participants to spread the distributions over the joint life expectancies of themselves and their beneficiaries. For more information on taking advantage of these new rules, visit the “Stretch IRAs” link.

 

Pre-LERO/72(t)

When would a 10% tax penalty* be imposed?

In today’s uncertain economy, many people find themselves struggling to make ends meet. Maybe they have lost their jobs and are looking for a new one, or perhaps unforeseen expenses are mounting and must be paid. Whatever the reason, many individuals who are younger than age 59 ½ are forced to tap into their retirement funds just to get by — regardless of the consequences. Many people are not aware that in addition to having the funds fully taxable as income, the IRS imposes a 10% penalty for withdrawing money from their qualified plans prior to age 59 ½. (*All references on this website to the 10% tax penalty are referring to the 10% excise tax imposed by the IRS for premature withdrawals.)

 

How can one avoid paying the 10% penalty on premature withdrawals?

Although one cannot avoid having the income taxed, there is a way to avoid the 10% penalty. Internal Revenue Code Section 72(t) allows an individual to take distributions from his or her retirement account before age 59½ without paying the 10% penalty. In addition, new rules as of January 1, 2002 and October 7, 2002 make Section 72(t) even more attractive.

The I.R.C. Section 72(t), which we call Pre-LERO, is the IRS rule governing early distributions of qualified retirement plans. Most retirement plans, whether they are 401(k)s, IRAs, 403(b)s or others, (with the exception of 457 Plans), have what is called the 59½, 10% rule. The 59 ½, 10% rule requires the owner of the plan to be at least age 59 ½ before taking a distribution or withdrawal from the plan. The consequential penalty of any premature withdrawal is 10% of the amount of the withdrawal. Pre-LERO, however, allows individuals to receive distributions from their qualified retirement plans without paying the 10% penalty, as long as certain requirements are met.

 

How does Pre-LERO work?

First, the money in the qualified retirement plan must be rolled into an IRA by using a vehicle designed for Pre-LERO distributions. A good example of an approved vehicle is a fixed annuity, which offers excellent guarantees and 100% safety.

Secondly, in order to comply with the Pre-LERO rules, an owner must take distributions from his or her retirement plan for at least five years or until he or she reaches age 59 ½ — whichever is longer. If the owner were 49½, he or she would have to take distributions until age 59½, which is 10 years. If the owner were 58, he or she would have to take distributions until age 63, which is 5 years.

Lastly, the distributions must be part of a series of Substantially Equal Periodic Payments (SEPP) received at least annually. The payments may be received monthly, quarterly or annually. There are three methods the IRS allows to calculate the periodic distribution: the Life Expectancy Method, the Amortization Method and the Mortality Table Method.

 

How do the different methods affect the periodic distribution amount?

The Life Expectancy Method produces the lowest annual distribution. This is a good choice for individuals who need access to their money without depleting their account too quickly. Since life expectancy changes every year, the payment amount will also change, increasing as the annuitant gets older.

The Amortization Method produces a level payment over the owner’s life expectancy, using a reasonable interest rate. Depending on the individual’s age, the payment amount may be two to three times higher than the Life Expectancy Method. (Note: The reasonable interest rate is determined each month by the Internal Revenue Service and is published as a base interest rate known as the Applicable Federal Rate or AFR. Due to this, fluctuation amounts in the interest rates will affect the amounts of distributions required to meet the rules for I.R.C. Section 72(t).)

The Mortality Table Method produces a level payment over the owner’s life expectancy, based on a reasonable mortality table and reasonable interest rate. It also produces the highest annual distribution of the three and is approximately 10% higher than the Amortization Method.

Let’s look at an example of a 48-year-old male named John, who needs to access the $400,000 he has in a 401(k). The first step is to roll his $400,000 into an IRA by using a fixed annuity, which is a vehicle approved for Pre-LERO distributions. We know that John will have to receive distributions until he is 59 ½, which means he will receive payments for 12 years. John’s age, the beginning amount of his 401(k), the number of years he must receive payments and the calculation method he chooses all affect the payment amount he will receive each year.

If John chooses the Life Expectancy Method, he would receive a payment of $8,456.66 for the first year. Because his life expectancy changes each year, his payment amount increases annually. By the 12th year John would receive a payment of $11,707.76. Because this method produces the lowest annual distribution and John’s money has been earning interest in the fixed annuity, at the end of 12 years he would still have $429,651.37 remaining in his retirement account.

If John chooses the Amortization Method, his annual payment would be $27,258.88. This payment amount stays the same for all 12 years. Using this method for a 12-year term would pay John a total of $327,105.60 and would leave him with $183,445.51 in his retirement account.

If John chooses the Mortality Table Method, his annual payment would be $29,114.20. This payment also stays the same for all 12 years. At the end of 12 years, John would have received a total of $349,370.40 and he would have $157,114.76 remaining in his retirement account.

At the end of the twelve years, John could choose to continue receiving annual payments, he could change the payment method or he could choose to stop receiving these distributions since he met the requirement of 5 years or 59½, thus avoiding the 10% penalty on all distributions to this point. If he stopped the payments, he would still have to meet the minimum distribution requirements at age 70½.

 

Can a person change the calculated method after distributions have begun?

As you can see from the previous example of John, the ability to use Pre-LERO can be very advantageous for those needing to tap into their retirement funds. The only problem was that individuals were not allowed to change the selected method once the distributions began. This meant that an individual who selected the Mortality Table Method risked depleting his or her entire retirement account, but he or she would have to pay hefty penalties to stop the withdrawals.

Then on October 7, 2002, the rules were changed. Now the IRS allows individuals to make a one-time­ change in the calculation method selected, without any penalty. (Once a change has been made, however, any additional changes will result in hefty penalties.) This change makes the Pre-LERO option much more attractive because it gives the owner some flexibility. For example, an individual who is unemployed could choose the Mortality Table Method to receive the maximum distribution to provide the extra income needed to make ends meet. Then, after steady employment is found, this individual could change to the Life Expectancy Method and receive the smallest annual distribution, thus protecting his or her retirement account.

If our example, 48-year-old John, needed the maximum distribution at the beginning to cover his financial obligations, he would select the Mortality Table Method. If, however, he found a steady job a few years later and changed to the Life Expectancy Method, which produces the lowest annual distributions, his ending retirement account balance would be considerably greater than using the Mortality Table Method for the duration of the 12 years.

Let’s say John decided to make this change after seven years. His annual payments would change from $29,114.20 to $9,773.59 in the eighth year. With the Life Expectancy Method, this payment amount would increase as his life expectancy changed. By the 12th year, his annual distribution would be $12,065.77. At the end of 12 years, John would have received a combined total of $258,232.77. Plus, because his fixed annuity was continually earning interest, John would have $320,688.77 remaining in his retirement account. If you add the two amounts together, John benefited from a total of $578,921.54, yet he only started with $400,000.

Furthermore, if John were to make the change from the Mortality Table Method to the Life Expectancy Method after five years instead of seven, he would have received total distributions of $231,946.21 and would have $382,223.80 remaining in his retirement account. In this case John would benefit from a combined total of $614,170.01, though he started with only $400,000.

 

Why take advantage of Pre-LERO?

As one can see by looking at the benefits the Pre-LERO option provided for the example, John, I.R.C. Section 72(t) may be the best life preserver one can find in troubled waters while trying to get his or her feet on dry land. Although Pre-LERO may not help find a job or make expenses shrink, it can help one meet financial obligations and provide for family needs without totally depleting one’s retirement account.