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
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
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 [email protected]
. RAY A. KNIGHT, CPA/PFS, JD, is managing
director of Capstone Planning Alliance, LLC, in
Winston-Salem. His e-mail address is [email protected]
PAs commonly advise clients not to touch their
savings in IRAs and employer-sponsored retirement plans
before age 59 1 / 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
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
Section 408(b) individual retirement annuities.
|Paying the Penalty |
More than 70% of the individuals who
received lump-sum distributions from their
retirement plans in 2001 spent them, subjecting
them to the IRC section 72(t) 10% early withdrawal
Source: Authors’ tabulations
from the “Survey of Income and Program
Participation,” 2001 Panel, Wave 7, U.S. Census
An early distribution
is one made before the participant reaches age 59 1
/ 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.
|Exhibit 1 :
IRC Section 72(t) Penalty Exemptions
There are 16 exemptions
including the 8 emergency-related ones discussed
in this article.
|IRC section 72(t)
to the disability of a participant.
||Participant must be disabled within
the meaning of IRC section 72(m)(7).
|Distribution as part of a
series of substantially equal periodic
payments.||Payments must not
occur less frequently than annually.
Payments from plans other than IRAs
or individual retirement annuities must
not begin before employee separates from
|Distribution due to separation from
service.||Does not apply if the
separation from service occurs before the
year the participant turns 55.|
not apply to IRA distributions or to
|Distribution less than
or equal to deductible medical expenses.
||Does not apply to pre-1997 IRA
|Distribution to unemployed participant
for health insurance premiums.
||Applies only to IRA distributions.
Participant must have received
federal or state unemployment
compensation for 12 consecutive weeks or
have qualified under the self-employment
Limited to amount of
health insurance premiums paid.
qualified higher education expenses of the
participant or spouse, or their children
or grandchildren.||Applies only
to IRA distributions.|
Does not apply
if participant qualifies for another
|Distribution for the first-time
purchase of a principal residence by the
participant or spouse, or their child or
grandchild.||Applies only to IRA
Distribution must be
used within 120 days to pay qualified
limit of $10,000.
Does not apply
if participant qualifies for another
|Distribution subject to loan
agreement.||Loan agreement must
be legally enforceable.|
Term of loan
cannot exceed five years unless
distribution is used to acquire a
must adhere to specified repayment
schedule and the amount of the loan is
|Distribution made to a beneficiary or
the estate of a participant on or after
the participant’s death.||Only
applies to spousal beneficiary if spouse
elects to leave plan assets in
participant’s name rather than rolling
them over into IRA established in spouse’s
distribution to ESOP participant.
||Distribution must meet conditions for
dividend deductibility established in IRC
|Distribution pursuant to federal tax
levy on plan under section 6631.
||Does not apply to pre-2000
distributions or distributions used to pay
federal income taxes in the absence of a
levy under IRC section 6631.|
|Distribution to alternate payee
under a qualified domestic relations
order.||Does not apply to IRA
|Distribution to federal retiree
electing lump sum credit and reduced
annuity.||Does not apply to
lump-sum distribution if retiree makes the
election and retires before the year he or
she reaches age 55.|
Applies to reduced
annuity payment regardless of age
retiree makes election and retires.
over into another qualified retirement
plan within 60 days of the distribution.
||IRS can waive the 60-day rollover
period if it believes the participant
missed the deadline because of a
“hardship” beyond his or her control.
|Distribution to correct
excess contributions.||Applies to
402(g), 401(k) and 401(m) plans and IRAs.
conversion from traditional to Roth IRA.
||Applies to entire distribution
(including portion of distribution
includable in income).
“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.
|Exhibit 2 :
Impairments Preventing Substantial Gainful
Loss of use of two limbs.
Progressive disease, such as
diabetes, multiple sclerosis or Buerger’s disease,
that resulted in the physical loss or atrophy of a
Disease of the heart, lungs or blood
vessels that resulted in a major loss of heart or
lung reserve (as evidenced by X-ray,
electrocardiogram or other objective findings)
such that minor exertion (for example, walking
several blocks, minor chores and using public
transportation) produces breathlessness, pain or
Inoperable and progressive cancer.
Damage to the brain or a brain
abnormality that resulted in severe loss of
judgment, intellect, orientation or memory.
Mental disease (for example,
psychosis or severe psychoneurosis) requiring
continued institutionalization or constant
Loss or diminution of vision to the
extent that the central visual acuity in the
better eye after correction is not better than
20/200, or the widest diameter of the visual field
of vision subtends an angle not greater than 20
Permanent and total loss of speech.
Total deafness uncorrectable with a
Source: Treasury regulations
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
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.
How Would You Advise This Client?
CPAs often find that clients
qualify for more than one exemption, and the real
challenge is to determine the best mix. Consider
the plight of Jack Winston, who lost his job in
Baltimore at the age of 52. He found new
employment in Chicago, starting in six months.
Jack has a daughter in college and no medical
insurance, and needs to purchase a new home. He
has little cash, but large balances in his 401(k)
retirement plan and several IRAs. Which, if any,
section 72(t) exemptions would you suggest to
provide Jack the liquidity he needs?
exemption clearly doesn’t apply. The equal
payments exemption isn’t suitable because Jack
cannot stop the payments in six months without
creating a modification. And because Jack is
younger than 55, he does not qualify for the
separation from service exemption. The medical
expense exemption will not work.
leaves four possibilities. Jack will qualify for
the health insurance premiums exemption but not
until he receives unemployment compensation for 12
consecutive weeks. If Jack does not own a home in
Baltimore, he might qualify for the first-time
home purchase exemption. However, if he owns a
home in Baltimore, he cannot meet the required
two-year waiting period. The loan agreement
exemption may work if Jack is prepared to meet the
formalities associated with it. The qualified
higher education expense exemption may cover some
of his daughter’s college costs, but only if Jack
does not qualify for one of the other
DISTRIBUTION OF SUBSTANTIALLY EQUAL PERIODIC
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
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.
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
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.
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 59 1
/ 2, or within five years of the date of the first
payment (even if the participant has reached age 59 1
/ 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 59
1 / 2 (but not on the payments received after
age 59 1 / 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 59
1 / 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.
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,
|Exhibit 3 :
Not Regarded by IRS as Modifications Subject to
the Recapture Tax |
change in payment |
|Regulations section 1.408a-4,
Q&A 12||Lump-sum distribution
from IRA in converting to a Roth IRA; the
series of substantially equal payments
established for the original IRA continues
on schedule with the Roth IRA.|
|Revenue ruling 2002-62
||Annual redetermination of the
variables used to calculate the equal
payments under the required minimum
distribution method sanctioned in notice
2002-62||One-time change from the
fixed amortization method or the fixed
annuitization method to the required
minimum distribution method (all of which
are IRS sanctioned methods in notice
89-25); change made to avoid premature
depletion of retirement account assets
that have declined in value.|
|Revenue ruling 2002-62
||Cessation of payments after exhausting
the balance in an IRA or qualified plan.
|Letter ruling 8919052
||Change from basing annual
distribution amount on the expected joint
lives of the participant and his or her
spouse to basing it on the expected life
of the participant after the spouse’s
891905||Change from payment
schedule providing for an uncertain number
of installments of each annual payment to
a payment schedule requiring the
distribution of each annual payment in
|Letter ruling 9514026||Change
in monthly payment date from the last date
of the prior month to the first day of the
month for which the payment is to apply.
|Letter ruling 9221052
||Lump-sum rollover from a
terminated qualified plan to an IRA that
distributes the same periodic amount with
the same frequency as the terminated
distribution from an IRA to make up for
periodic payments missed between the dates
of termination of a qualified plan and its
rollover; without lump-sum distribution,
annual IRA payment would not equal the
annual payment from the terminated
clause setting the current year payment
equal to 103% of the previous year’s
payment adopted before periodic payments
200052039 and 200050046||Some or
all of participant’s account balance
transferred to spouse pursuant to divorce.
|Letter ruling 200027060
||Payment schedule for retirement
funds received pursuant to divorce not in
conformity with former spouse’s
|Letter ruling 200309028
||Payment amounts separately calculated
for multiple IRAs; no commingling of funds
from various IRAs.
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
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)).
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
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
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
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)).
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.
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)).
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.
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
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.
Adviser’s Guide to Tax Planning Strategies for
Retirement by William R. Bischoff, CPA, 2005
(paperback, # 091017JA).
Super Tax Planning Strategies for Individual
Clients’ Retirement Accounts (# 731295JA).
For more information or to order, call the
Institute at 888-777-7077 or go to .
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,
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)).
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
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.