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On Oct. 3, the Internal Revenue Service published a ruling that substantially eases the potential income tax burden for Individual Retirement Account holders who elect to begin withdrawals before reaching the age of 591/2. Under prior law, required withdrawals made as a “series of substantially equal periodic payments” or “SOSEPP” could wipe out an individual’s IRA if a market downturn reduced its value. Moreover, switching among the methods of calculating the required distribution under a SOSEPP was a “change,” subjecting the funds withdrawn pursuant to the SOSEPP to an additional 10 percent tax plus interest. Revenue Ruling 2002-62 changes all that. Not only does it provide welcome relief from the risk of depleting the IRA; it also permits the plan participant to make a one-time election to change the method for determining the annual payment from one that results in a fixed amount to one that changes yearly based upon the account value, without incurring a penalty. The new ruling provides less flexibility in other areas, however. A little background is helpful to understand the change. Internal Revenue Code �72(t) assesses an additional 10 percent tax on distributions made from an IRA before age of 591/2. There are listed exceptions, however. One exception, �72(t)(2)(A)(iv), permits the plan participant to withdraw plan assets before reaching age 591/2 if the withdrawals are part of a SOSEPP, payable at least annually, made for the life (or life expectancy) of the participant or for the joint lives (or joint life expectancies) of the participant and the designated beneficiary. The authors of �72(t) clearly intended that, theoretically, the SOSEPP would deplete the IRA assets gradually over the plan participant’s life or the joint lives of the participant and the beneficiary. However, �72(t)(4) allows the participant to modify or discontinue the SOSEPP any time after he or she reaches age 591/2 or after the fifth anniversary of the first payment of the series, whichever is later. Until then, both the SOSEPP election and the method chosen for calculating the required distribution under the SOSEPP are irrevocable. Upon modification, �72(t)(4) imposes the additional 10 percent tax on the pre-age 591/2 distributions from the IRA and interest is charged on that amount for the deferral period. Q & A On Jan. 1, 1989, the IRS published Notice 89-25, a series of questions and answers on miscellaneous issues affecting qualified plans. Q&A-12 delineated three acceptable methods for calculating the required annual distribution under the SOSEPP exception to �72(t). First, the annual payments could be determined using a method that would be acceptable for purposes of calculating the minimum distribution required under �401(a)(9), commonly known as the “required minimum distribution method.” Under this approach, the payment could be determined based on either the life expectancy of the plan participant or the joint life and last survivor expectancy of the plan participant and his or her beneficiary. Second, annual payments could be calculated under the “amortization method” in which the annual distribution was determined by amortizing the plan participant’s account balance over a number of years equal to the life expectancy of the plan participant (or the joint life expectancy of the plan participant and his or her beneficiary) at an interest rate that did not exceed a reasonable interest rate as of the date the payments began. The third method, or “annuity method,” determined annual payments by dividing the plan participant’s account balance by an annuity factor calculated to be the present value of a $1 annuity beginning at the plan participant’s attained age in the first distribution year and continuing for the life of the plan participant. The annuity factor was required to be derived from a reasonable mortality table using an interest rate not exceeding a reasonable interest rate on the date payments began. All the methods approved under Notice 89-25 required determination of an account balance in order to compute the payment calculation. However, the notice did not clarify the date to use for determining the account balance. Under the annuity and amortization methods plan, participants often used the account value on the date of the first distribution. As these payments were fixed on the date of the initial distribution, future account balances were irrelevant. A plan participant electing the required minimum distribution method typically used the account balance on the preceding Dec. 31st, as is required for minimum distributions under �401(a)(9). Notice 89-25 did not specify a “reasonable interest rate” or index nor did it define a “reasonable mortality table.” Thus, the plan participant had wide latitude to use a mortality table and interest rate that produced the most beneficial result, although no certainty that such would be accepted as “reasonable” by the IRS. A LITTLE FINE TUNING Revenue Ruling 2002-62, which modifies Q&A-12 of Notice 89-25, maintains the three basic methods for determining the annual payments to be made under a SOSEPP, but with some modifications. Under Ruling 2002-62′s definition of the “required minimum distribution method,” the annual payment is determined by dividing that year’s account balance by the number from that year’s chosen life expectancy table. Therefore, the account balance, the number from the chosen life expectancy table and the resulting annual payment are all recalculated each year. The ruling confirms that, even if the payment amount changes each year, as long as the method for determining the payments has not changed, no modification will be deemed to have occurred. As the account balance is revalued each year, the required annual payment varies with market performance. Thus, while technically the account will never be exhausted, as is possible with a required fixed payment, this payment method makes the size of the annual distribution subject to market fluctuations and potentially much smaller or larger than if the plan participant implemented another method of calculation. The annual distribution under the “amortization method” is simply calculated as if the IRA were actually a loan, the principal balance of which is the account value at the date of the first distribution, the term of the loan equaling the life expectancy of the individual (determined in accordance with proposed �1.401(a)(9)-1 of the regulations) and the interest rate being one that does not exceed a reasonable interest rate on the date the payments begin. Once the distribution amount is determined based on the data in the initial year of distribution, the payment remains fixed for the term regardless of investment performance. Ruling 2002-62 describes the “annuity method” in terms almost identical to Notice 89-25. However, instead of permitting any “reasonable” mortality table, the ruling requires the use of the IRS mortality table, attached to the ruling as Appendix B. As the ruling notes, the account balance, the annuity factor and the chosen interest rate are selected once for the first distribution year, and the resulting annual payment is then fixed for each succeeding year. The annuity method and amortization method are very similar, each providing a fixed payment amount regardless of the size of the remaining IRA balance. The major difference is the size of the fixed annual payment amount calculated using each method. Under prior law, these two fixed payment methods threatened to deplete the entire IRA during an unexpected drop in account value, potentially subjecting the plan participant to additional tax and interest under �72(t)(4) both for failure to receive a substantially equal payment and for an improper cessation of payments once the account balance dropped to zero. EASING THE RISK Ruling 2002-62 provides, at �2.03, two “special rules” easing the risk of depleting the IRA under a SOSEPP. First, plan participants may now switch from one of the fixed payment methods (the annuity method or the amortization method) to the required minimum distribution method, thus averting depletion. Such a change will not be deemed a modification for purposes of �72(t)(4) and, therefore, no additional tax will be assessed. Once the plan participant elects to switch, however, the required minimum distribution method must be followed in all subsequent years. The ruling deems any additional subsequent change from the required minimum distribution method to be a modification subject to the additional tax and interest of �72(t)(4). Second, even if the plan participant chooses not to switch and fully depletes the account, the other special rule assures the plan participant that (i) the SOSEPP will not be subject to additional tax under �72(t)(1) for failure to take an equal fixed payment when the account drops below the annual payment amount, and (ii) the cessation of payments after the account balance is zero will not be deemed a modification under �72(t)(4). Ruling 2002-62 remains flexible in determining the account balance to be used in calculating the periodic payment. The requirement is that the account balance be determined in a reasonable manner based on all the facts and circumstances. The ruling provides an example indicating that a plan participant electing a SOSEPP (with annual payments to be calculated under the required minimum distribution method) in July could use any valuation date from Dec. 31st of the prior year through the date of distribution. In subsequent years the taxpayer can again select either Dec. 31st of the prior year or a date within a reasonable period before the current distribution. NOT SO FAST THERE Ruling 2002-62 is less lenient as to its permissible interest rates and life expectancy tables, removing some of the flexibility of prior law. Whereas Notice 89-25 permitted the plan participant to use any “reasonable” interest rate in calculating a SOSEPP, Ruling 2002-62 now restricts the plan participant to any interest rate that is not more than 120 percent of the federal mid-term rate, as determined under �1274(d), for either of the two months immediately preceding the month in which the distribution begins. Under Notice 89-25, a plan participant electing the required minimum distribution method prior to Jan. 1, 2003, could adopt one of the three life expectancy tables contained in the Supplement to Publication 590 (modified in June 2002). Under the amortization method, life expectancies were determined in accordance with proposed Regulation �1.401(a)(9)-1. Also, Notice 89-25 allowed “any reasonable mortality table” to be used in determining annual payments under the annuity method. Prior to Ruling 2002-62, an individual could have used the life expectancy tables found in �1.401(a)(9)-9 of the proposed regulations or the life expectancy tables found in Regulation �1.72-9. Ruling 2002-62 now requires a plan participant to choose one of (i) the Uniform Table (attached to the ruling as Appendix A), (ii) the single life expectancy table found in �1.401(a)(9)-9, Q&A-1 of the final regulations issued in April 2002 or (iii) the joint life expectancy table found in �1.401(a)(9)-9, Q&A-3 of the regulations. HOW IT PLAYS OUT To illustrate the impact of Ruling 2002-62 on each of the three alternate methods of determining substantially equal periodic payments under �72(t)(2)(A)(iv), assume a 50-year-old elected a SOSEPP on Jan. 1, 1999. On Dec. 31, 1998, the account balance, totaling $1,000,000, was invested in equities. Since the date of the SOSEPP election, the IRA balance has declined 10 percent per year, excluding distributions. The plan participant’s results under each of the three methods would appear as demonstrated in Table 1. Under prior law, once the annual payment was determined, the distribution under the annuity method and amortization method remained fixed for the greater of five years or until the plan participant attained the age of 591/2. Thus, the plan participant in this example would have been required to continue the distributions until the age of 591/2. Any modification in the distribution would have disqualified the entire SOSEPP, subjecting the plan participant to the additional 10 percent tax plus interest on all of the distributions taken prior to age 591/2. Due to the low IRA balance, such a disqualifying modification would have occurred in 2006 under the annuity method and in 2007 under the amortization method. Ruling 2002-62 rescues the plan participant. First, the ruling specifically states that the additional 10 percent tax and interest under ��72(t)(1) and 72(t)(4) will not be imposed under these circumstances. Second, the ruling permits the participant to switch from the annuity method (or the amortization method, if such method was initially chosen) to the required minimum distribution method. Once switched, the required minimum distribution method must be followed for the remaining years until age 591/2 (or in other cases, five years if that would extend beyond age 591/2). Thus, in 2003, the $90,017 fixed distribution required under the annuity method could be changed to a distribution of $12,796.20 ($377,488/29.5) under the required minimum distribution method. Although not clear from the ruling, many believe that if an individual makes the modification in the middle of the year and the distributions to date exceed the required minimum distribution for that year, then no further distributions are required for that year. Assume that the plan participant elected to convert from the annuity method to the required minimum distribution method on June 1, 2002, when the account balance totaled $440,000. The participant’s spouse is 50 years old. As demonstrated by the chart below, electing to instead use the required minimum distribution method could produce several differing payment amounts depending on (i) the date the account balance is valued, (ii) the chosen life expectancy table and (iii) the selected beneficiary. See Table 2. The ruling permits the plan participant to change the valuation date and, if the joint and survivor table is chosen, to change the beneficiary, each year based on the participant’s changing needs. Ruling 2002-62 replaces Notice 89-25 for any SOSEPP beginning on or after Jan. 1, 2003. Plan participants may choose to apply the ruling to SOSEPPs distributing the first year’s payment in 2002. In addition, if a SOSEPP has begun prior to 2003 and complies with �72(t)(2)(A)(iv), the ruling permits the method of calculating the annual payments to be changed at any time to the required minimum distribution method. The plan participant may also change the life expectancy table used in calculating the required minimum distribution. Despite restricting plan participants’ options for choosing an interest rate and life expectancy table, Ruling 2002-62 provides welcome relief from the rigid distribution schedules and corresponding risk of exhausting an IRA and exposure to additional tax imposed by �72(t). The following charts summarize the key differences between Notice 89-25, Q&A-2 and Revenue Ruling 2002-62. Notice 89-26, Q&A-12 See Table 3. Revenue Ruling 2002-62 See Table 4. The authors are with PNC Advisors of Moorestown and Philadelphia. Gaudio is a senior wealth planner, Immel and Babitz are attorneys and senior wealth planners and Pappaterra is an attorney and corporate-wide director of wealth planning. The material presented is of a general nature and does not constitute provision of legal, financial planning, tax or accounting advice to any person.

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