IRC Section 72(q) Can Eliminate Tax Penalties For Premature Annuity Distributions

Note: Annuities are complicated instruments, so this article can’t possibly provide all the information you’ll need to know about them, and this does not constitute professional advice. You’ll need to consult your tax advisor and financial advisor when making decisions about these products. This article deals with Nonqualified Annuities – ie. annuities purchased with after tax dollars. Similar rules apply to Qualified accounts like IRAs.

It’s my money and I need it now!

Help! My Money’s Tied Up!

Non-qualified Annuities are great vehicles for allowing you to accumulate money tax deferred. But if you own one, you are also likely aware of some of the tax issues that could be triggered by accessing your account early:

  • Withdrawals are taxable as LIFO – If the annuity has not yet been annuitized, it is taxed on a “Last In First Out” or LIFO basis. The dollars that come out are presumed to be from the most recent that went in. The original principal (which isn’t taxed) remains untouched, while the taxable earned income portion is withdrawn.  These are included in your income taxes that year.For example, if you put $100,000 in (after tax), as long as the remaining balance remains over $100,000, every penny you withdraw is taxable as earnings. Only after the account falls below $100,000 (your “basis”) are you presumed to be using your contributed money. Every dollar of contributed money you take lowers this threshold, or “basis” in the account. If you take $20,000 of the original money, your basis is now $80,000, but the “basis” can also be increased by subsequent contributions.
  • Withdrawals prior to the age 59 1/2 incur a 10% IRS tax penalty –   The penalty applies to the portion of withdrawals that have yet to be taxed – the growth portion.  This is in addition to regular income tax also imposed on those amounts.
  • Annuities have contractual early withdrawal charges –  Like bank certificates of deposit, annuities have impose early withdrawal penalties if you take money out before an initial period. A typical annuity has a surrender charge that declines year by year. For example, a seven-year surrender period may impose a 7 percent fee if you bail out in the first year, 6 percent during the second year, and so on until there is no penalty after seven years. Your annuity may have a limited free withdrawal feature that allows withdrawals of 10% per year without a charge. Some annuities also waive withdrawal charges in certain situations, such as death, confinement in a nursing home or terminal illness.
  • Withdrawals over a certain limit may cancel a Living Benefits Rider – This is an optional rider on your annuity. The Living Benefits Rider guarantees the contract principal and/or a certain rate of hypothetical growth as long as certain conditions are met (such as annuitizing the contract instead of taking a systematic withdrawal.)

But It’s My Money and I Need it Now!

You may be able to avoid the 10% penalty if you meet one of several exceptions (there are additional exceptions for qualified retirement plans):

  • After age 591/2;
  • If you need to withdraw annuity funds as part of a divorce settlement, personal injury settlement, or similar legal ruling;
  • In the event of disability;
  • In the event of death;
  • As part of a series of substantially equal payments taken over life expectancy.
  • In a 1035 Exchange: You can move your annuity account values into a different annuity. Just be sure that you are past the original surrender period and won’t be charged a penalty in doing so. Bonus annuities may pay an upfront bonus to make up for such penalties, but beware – they typically have higher fees in return.

You can read more about these exceptions here and in IRS IRS information,  including Publication 575.

72(q) to the Rescue! – Substantially Equal Periodic Payments

You can access your annuity without paying the tax penalties and use it for any need you have – including mortgage payments, childcare expenses, to pay for college or start a business if you meet certain criteria that are outlined under IRS Section 72(q,) You can similarly access your IRA funds under Section 72(t). A very advantageous way to avoid the 10% penalty on distributions from an annuity before you are 59 1/2 is to take them  in “Substantially Equal Periodic Payments.”

Here are the rules:

  • Substantially Equal Periodic Payments” must be taken at least annually.
  •  The payments must be based on your life expectancy.
  • You must continue the payments for the later of 5 years or until you turn 59 1/2 (whichever is longer.)
  • If you modify the amount or method of payment or discontinue the payments before the later of 5 years or age 59 1/2, the 10% penalty applies retroactively so you may have to pay all back taxes with penalties and interest.
  • Distributions may be subject to surrender charges as described in your annuity contract.
  • Federal and State ordinary income taxes are still applicable.

Payment Methods:

There are three acceptable methods of calculating 72(q)/72(t) distributions, as described below: the Life Expectancy Method, the Amortization Method, and the Annuitization Method. DON’T PANIC! An interactive calculator can help you compare your payouts under each of these three methods. If you are serious about tapping your funds early, your financial advisor will be able to run these scenarios for you. At the End of this article, I will provide a Wonk Section to review the three methods in greater detail.

The Bottom Line: Your Case Study

Situation: You and your spouse, both age 56, need a steady source of income to meet your financial obligations as you make a job transition or start a business.

Setting: You’ve accumulated a substantial amount of money in an IRA or annuity.

Solution: Under IRS Code Section 72(q) for Annuities or 72(t) for IRAs, you can withdraw a set amount every month for five years to cover expenses. You’ll only pay income taxes on the distributions, but you won’t incur the 10% penalty tax.

Wonk Section – How 72(q) Distributions are Calculated

Anyway, for your curiosity, here is a brief review of the three methods:

  1. Life Expectancy Method
    • Calculated by dividing the annuity account balance by a life expectancy factor that is published in the IRS tables
    • Payment amounts must be recalculated annually
    • Since payments are recalculated based on life expectancy, the payment amount will vary from year to year. Generally, this method provides for smaller payments in the beginning, with payments increasing annually over time.
  2. Amortization Method
    • Calculated by amortizing the annuity account balance over the life expectancy of an individual, or the joint life expectancy of an individual and designated beneficiary, by using IRS mortality table and reasonable interest rate.*
    • Payments are NOT recalculated annually and remain constant over time
  3. Annuitization Method
    • Calculated by dividing the annuiy account balance by an annuity factor that is published in the IRS mortality tables and a reasonable interest rate.*
    • This method does NOT require annuitization of the contract
    • Payments are not recalculated annually and remain constant over time

A tax advisor should carefully consider the initial funding amount, payment method (including interest rate assumption), payment frequency, and investment options. Investment performance should be monitored and periodically adjusted as necessary to ensure assets are sufficient to continue the specified IRS Section 72(q) payment amount. IRS general information letter (INFO 200-0226) states that the interest rate used for 72(q)/72(t) distribution calculations must be a “reasonable interest rate” equivalent to 120% of the Federal Mid-Term Rate. Your client should consult with his/her tax advisor to determine the assumed interest rate to use.

Snap Principle of Annuity Planning

They’re great vehicles for tax deferral and generating income. To make them work for you, make sure you understand them well.