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New Wrinkle In Pre-59 1/2 IRA Withdrawals

If you take money from your IRA before age 59½, you’re generally required to pay a 10% penalty to the IRS, in addition to the regular income tax that’s normally due on that money. But there’s a key exception. You can take a series of “substantially equal periodic payments” (SEPPs) from the IRA without penalty (though you’ll still owe income tax). To qualify, the SEPPs must continue for least five years or until age 59½, whichever is later. And you have to use one of three basic methods for determining how much to take out. Make a mistake or change your method, and you’ll generally have to pay the price—being liable for the 10% penalty after all.


Now, though, in a surprising private letter ruling (IRS PLR 201051025), the IRS allowed a taxpayer to avoid the penalty tax, even though three glaring mistakes were made in calculating his periodic payments.

Here’s what happened. The taxpayer—let’s call him John—was younger than 59½ when he arranged to receive SEPPs from his IRA. He instructed the custodian for his account to distribute the initial SEPP in a single sum in Year 1 and in equal monthly installments thereafter.

Mistake #1:John discovered that the IRA custodian had distributed an incorrect amount for the first month of Year 2. Subsequently, he directed the custodian to make a corrective distribution from the IRA, taking the shortfall into account.

Mistake #2:The IRA custodian distributed an incorrect amount from the IRA in the second month of Year 2. This shortfall was also covered by a corrective distribution for the first two months of Year 2.

Mistake #3:The IRA custodian made only 11 monthly distributions to John, instead of payments in the usual 12 months, in Year 6. John only learned of the error when he reviewed the Form 1099 for the year. He then proposed to receive a “make- up distribution” in Year 7 that would satisfy the annual payment distribution requirement for Year 6.

John submitted a request for a ruling from the IRS that the corrective distribution proposed for Year 7 and the corrective distributions in the previous years would not be treated as a modification of the SEPP payments. The IRS accepted his arguments, absolving John of all blame and concluding that he wasn’t subject to the 10% tax penalty in this situation.
 
As encouraging as that leniency may seem, however, there’s no reason to expect it to happen regularly. In the past, similar taxpayer mistakes have been penalized. For example, the tax agency recently imposed the 10% penalty when a mistake by a taxpayer’s financial advisor resulted in two trustee-to-trustee transfers mistakenly being made at the same time (IRS PLR 20070023). So the best approach is to get things right from the outset. We can work with you to avoid costly mistakes.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.




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