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Join Date: Apr 2004
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IRA early W/D- Private-letter ruling
For those who can afford the luxury of an early retirement, the Internal Revenue Service has issued private-letter rulings that potentially give retirees more flexibility - and sometimes more money - in making early withdrawals from individual retirement accounts.
While private-letter rulings don't create a legal precedent, the recently released rulings essentially permit the creation of new methods that people can use to take early distributions from IRAs before the age of 59%BD; and avoid the 10% early-withdrawal penalty.
"What this now allows you to do is to set up a program where your withdrawals will mirror the market," said Barry Picker, certified public accountant and certified financial planner who is a sole practitioner in New York.
"In a down market, your withdrawals will be less, and, therefore, you won't run the risk of running out of money, while in an up market, you get to take out more each year," he said. "It really is, to me, the best of all worlds."
Under the existing IRS code, there are only three ways for an early retiree to withdraw IRA money without penalty. They are known as the life expectancy, annuitization and amortization methods.
Once a taxpayer chooses a method of payments - referred to as "substantially equal periodic payments" or SEPP - the individual, for the most part, has to stick with it. Withdrawing more or less than allowed can be a costly mistake, triggering a 10% penalty and back interest on the late penalties since the distributions began.
Of the three methods, the amortization and annuitization methods tend to allow early retirees to take out the highest amounts, tax experts said. The methods are basically calculated using a person's life expectancy and the federal mid-term interest rate at the time.
The problem, according to some tax experts, is that once the payment is calculated, it is fixed for the length of the SEPP schedule.
That means the fixed payments continue until the person reaches 59%BD; or five years from the start of distribution, whichever is later.
After that, they are free to withdraw money like any retiree.
"But for an individual who starts payments in their early 50s or 40s, 'until 59%BD;' is long enough to create some potential problems under the 'fixed' amount," said Michael Kitces, director of financial planning at Pinnacle Advisory Group Inc. in Columbia, Md.
What the IRS did in its private-letter rulings is give the affected taxpayer the green light to recalculate the amortization and annuitization schedule each year, as opposed to its remaining fixed.
The letters were dated in May but weren't released publicly until this month, when they appeared in the IRS' weekly bulletin.
"Someone applied to the IRS and said, 'I have a slightly different version of a formula that I want to use to calculate SEPP payments. I want to recalculate every year based on my life expectancy and interest rates at the time,' and the IRS basically said, 'OK, we will consider that to be a reasonable method to calculate substantially equal periodic payments,'" Mr. Kitces explained.
"The benefit of this is, even if there is some market fluctuation year to year, over time, your account balance is likely to rise, and if it doesn't rise and just stays even, the fact that interest rates are trending up - and your life expectancy, by definition, gets shorter as you age - means your payments are likely to get larger and larger each year," to keep pace with inflation, he said.
Patricia A. Thompson, a CPA and partner with Piccerelli Gilstein & Co LLP in Providence, R.I., agrees that the rulings give more flexibility to distribution methods, "but the downside is that you have to be prepared to take less if the market goes down. So, I guess, keeping that in mind, those are favorable rulings," she said.
Previously, only the life expectancy method allowed taxpayers to recalculate each year.
Under that method, individuals take their IRA account balance at the end of the year and divide it by their life expectancy to come up with their annual withdrawal amount.
Still, it can be risky for tax professionals and financial planners to rely on these IRS private-letter rulings for their clients.
An IRS spokeswoman said such rulings aren't "precedent-setting documents" and apply only to the particular case for which the letter was sought.
"However, it can give an indication of the agency's thoughts on this issue," the spokeswoman said.
While the rulings provide an idea of the IRS' mind-set, "the problem is that they can change their thought process, and many times they do," Mr. Picker said.
He recommends that taxpayers get their own private-letter ruling if they want to deviate from the standard distribution procedures.
"It's like an insurance policy," Mr. Picker said. "Once you get your own private-letter ruling, then the government can't attack what you do."
Questions remain, however, about whether the new rulings would apply to taxpayers who have already begun to take early distribution payments.
"It's not really clear whether that would be allowable, but presumably not," Mr. Kitces said.
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