Iin a recent private letter ruling, that could best be described as not taxpayer friendly, the Internal Revenue Service has ruled that a transfer of assets from one IRA to another IRA, while the taxpayer is taking distributions that are part of a series of substantially equal periodic payments, is an improper modification.
As a result, the taxpayer is subject to the 10% early withdrawal penalty on all distributions taken from the IRA. Additionally, the Service ruled that the taxpayer cannot correct the situation by transferring the assets back to the first IRA.
Facts
The taxpayer in this case, a 56-year-old woman, maintains two IRA accounts with the same custodian. In 2002, she commenced taking distributions from one of the IRAs that was designed to avoid the 10% penalty for early withdrawals from an IRA. She calculated her annual distribution amount using the fixed amortization method, which is one of the approved methods for computing a series of substantially equal periodic payments, under section 72(t).
At some point, the taxpayer consulted with her financial advisor to discuss whether she should move a portion of the equities in the IRA in question into cash. Her financial advisor informed her that while she could convert a portion of her IRA into cash without any penalties for the conversion, he indicated to her that her current IRA custodian did not offer certificates of deposit as an investment option. He therefore suggested that she transfer a portion of the IRA to a new custodian.
She then did a trustee to trustee transfer of a portion of the IRA to the new custodian. At the same time, however, she also transferred all of the second, non-72(t) IRA into the same account at the new custodian.
The taxpayer was subsequently informed that the transfer she had made was a modification of her series of substantially equal periodic payments, which would trigger the 10% penalty, plus interest, on all distributions taken since 2002.
At that point the taxpayer filed a request for this private letter ruling asking that the previous transfers not be considered a modification, and a proposed transfer back to the original IRA also not be considered a modification.
Background
Section 72(t) of the Internal Revenue Code imposes a 10% additional tax, commonly referred to as a penalty, on early distributions from retirement plans including IRAs. That section also lists a series of exceptions to the 10% penalty. One exception, the one in play here, is that the penalty will not be imposed on early withdrawals if the taxpayer is taking a series of substantially equal periodic payments and the payments continue for five years or until the taxpayer attains age 59 1/2, whichever is longer. However, if the computed distribution is modified in any way, other than by reason of death or disability, the 10% penalty will be imposed on all distributions taken prior to the taxpayer attaining age 59 1/2. In addition, an additional amount equal to the interest, computed as if the penalty was payable in the early years, is imposed.
Notice 89-25 and Rev. Rul. 2002-62 offers guidance on how the series of substantially equal periodic payments can be calculated. Three methods are approved for making the calculation. They are the minimum distribution method, the fixed amortization method, and the fixed annuitization method.
Rev. Rul. 2002-62 further provides that under all three methods the calculation is made with respect to the account balance as of the first valuation date selected. It further holds that any addition to the account balance other than through the normal gains or losses, or any non-taxable transfer in or out of the IRA accounts in question, will be considered a modification that will trigger the 10% tax.
Discussion
Based upon the facts in this case, the Service determined that the taxpayer had made an improper modification when she transferred a portion of the IRA into a new account. It further ruled that the taxpayer could not correct this action by reversing the transfer.
It has always been my feeling that the provision prohibiting transfers into or out of an IRA that was involved in a series of substantially equal periodic payments was designed to avoid playing with the balance if, for example, the account was being depleted due to poor investment results and the taxpayer wished to continue taking the same distribution. However, the Service appears to be taking a very hard line and reading the word “transfer” literally.
In this case, the Service could make a good argument that a modification had occurred because of the fact that when a portion of the involved IRA was transferred to the new custodian the entire balance of the second IRA was transferred into the same account. This resulted in a co-mingling of the IRA money from which a series of substantially equal periodic payments was being taken, with other non-involved IRA money.
However, the Service did not give the co-mingling as a reason. Rather, the Service stated, in the ruling, that the mere transfer of a portion of the account from one IRA to a second IRA constituted a modification.
Conclusion
The hard-line that the Service is taking on this issue makes it extremely important that individuals who are taking distributions that are part of a series of substantially equal periodic payments be vigilant. The penalties for blowing up the plan are significant, and the IRS is not forgiving.
