Substantially Equal Periodic Payments

Lachlan is 54. He takes his 400,000 dollar inheritance and buys a NONQUALIFIED SINGLE PREMIUM IMMEDIATE ANNUITY that begins paying him a life income the following month. His brother, also 54, instead puts 400,000 dollars into a deferred annuity and takes a 30,000 dollar withdrawal of gain the same year. Which of them faces the 10 percent premature distribution penalty on the taxable amount?

1. A.Both, because the 10 percent penalty applies to any taxable annuity amount received before age 59 and one half without exceptionThe penalty has several exceptions, including death, disability and substantially equal periodic payments for life.
2. B.Neither, because the 10 percent penalty applies only to qualified plans and IRAs, not to nonqualified annuitiesA parallel 10 percent penalty applies to premature distributions from nonqualified annuity contracts as well.
3. C.Only the brother, because an ad hoc withdrawal of gain before 59 and one half is penalized while an immediate life annuity qualifies for the periodic payment exceptionCorrect. Immediate annuitization for life fits the exception; the deferred contract withdrawal does not.
4. D.Only Lachlan, because annuitizing before 59 and one half accelerates the entire gain into the penaltyAnnuitization does not accelerate gain, and the immediate life annuity is precisely the arrangement the exception protects.

Why: The 10 percent penalty on premature annuity distributions applies to amounts taken before age 59 and one half, but it carries a specific exception for payments that are part of a series of substantially equal periodic payments made for life or life expectancy. A single premium IMMEDIATE annuity annuitized at purchase falls squarely within the immediate-annuity and periodic-payment relief, so Lachlan escapes the penalty on the taxable portion of his payments. His brother made an ordinary pre-annuitization withdrawal from a deferred contract, which is LIFO taxable gain and is subject to the 10 percent penalty because he is under 59 and one half and no other exception applies.

Corbin Securities is reviewing early distributions taken by clients from traditional IRAs before age 59 1/2. All of the following distributions escape the 10 percent additional tax EXCEPT one used to:

1. A.Fund a first time home purchase, up to the 10,000 dollar lifetime limitThe first time homebuyer exception applies to IRAs up to a 10,000 dollar lifetime cap, waiving the penalty.
2. B.Pay off credit card balances and other consumer debtCorrect. General debt repayment is not an exception, so this distribution is taxable and carries the 10 percent additional tax.
3. C.Pay qualified higher education expenses for the owner's childQualified higher education expenses are an enumerated exception, so no 10 percent penalty applies, though the distribution is still taxable.
4. D.Support the owner after she becomes totally and permanently disabledTotal and permanent disability is a listed exception to the 10 percent additional tax.

Why: The Internal Revenue Code lists specific exceptions to the 10 percent additional tax on early IRA distributions, including qualified higher education expenses, a first time home purchase up to a 10,000 dollar lifetime limit, total and permanent disability, death of the owner, substantially equal periodic payments, unreimbursed medical expenses above the applicable floor, and an IRS levy. Paying down ordinary consumer debt is not on the list, so that distribution is fully taxable AND subject to the 10 percent penalty.

Fabien, 47, owns a MODIFIED ENDOWMENT CONTRACT with substantial gain. He asks his producer to identify a circumstance in which he could take money out of the MEC and have the taxable amount escape the additional 10 percent penalty. Which circumstance qualifies?

1. A.He takes the money as a policy LOAN rather than as a withdrawalOn a MEC a loan is treated as a distribution. It is taxed gain first and is subject to the penalty just like a withdrawal.
2. B.He has owned the contract for more than seven years, so the 7-pay period has expiredMEC status is permanent once acquired. The passage of the 7-pay period does not undo it or relieve the penalty.
3. C.He becomes disabled within the meaning of the tax rules before taking the distributionCorrect. Disability is one of the recognized exceptions to the 10 percent penalty on MEC distributions.
4. D.He uses the entire distribution to pay premiums on a different life insurance policyHow the money is spent is irrelevant. There is no premium-payment exception to the penalty.

Why: MEC distributions are taxed gain first and, if the owner is under 59 and one half, carry an additional 10 percent penalty on the taxable portion. The penalty exceptions mirror those for annuities: the owner reaching 59 and one half, becoming disabled, or taking the money as part of a series of substantially equal periodic payments over life or life expectancy. Becoming disabled is therefore a qualifying circumstance for Fabien. Note that the exceptions relieve only the PENALTY. The distribution remains taxable as ordinary income to the extent of gain in every case.

A 50-year-old early retiree wants to draw on her traditional IRA now without the 10 percent penalty, and no statutory exception such as disability applies. She can:

1. A.Begin substantially equal periodic payments based on life expectancy, continuing for five years or until 59 1/2, whichever is LONGERCorrect - SEPP is the age-independent escape from the penalty, with the longer-of duration requirement.
2. B.Withdraw up to 50,000 dollars penalty-free as a hardship distributionHardship provisions belong to employer plans and do not, by themselves, waive the 10 percent penalty in any case.
3. C.Take any withdrawals she likes penalty-free after certifying early retirementNo certification exception exists for IRAs - retirement status alone never waives the penalty.
4. D.Begin substantially equal payments and stop them at age 55Stopping at 55 modifies the schedule before 59 1/2 - the penalty and interest then apply retroactively to every payment.

Why: Section 72(t) permits penalty-free withdrawals at any age through substantially equal periodic payments (SEPP) based on life expectancy. The payments must continue for five years or until age 59 1/2, whichever is LONGER - for her, until at least 59 1/2. Modifying or stopping early retroactively imposes the penalty plus interest on all prior payments. The clue is no other exception applies. Review: early distributions.