72t Distribution to show taxable income
Hello,
I have a client who is 56 years old and retiring Dec 31. He has two IRAs and a 401(k). In the 401(k) he has $100,000. He is looking to purchase medical insurance through Covered California. Given he retired prior to age 59.5, the plan was to take distributions from his trust accounts until he turned age 65, creating little to no taxable income each year (mostly has muni bonds).
According to Covered California he needs to show at least $35,000 in taxable income each year. He will be receiving subsidies on his annual premium, however his income falls below $35,000 a year in taxable income, he will have to pay penalties equal to the subsidies received. In Covered California’s eye, if he has less than $35,000 in income he should have been on Medi Cal. The client also does not want to be on Medi Cal for various reasons, mainly it’s unfair and others need it more than he does.
Given he needs to show $35,000 in income (his wife has some taxable income) can he take $20,000/yr distributions from his 401(k) assets over the next 5 years under the 72t Rule without penalty? Vanguard, the 401(k) custodian said he could.
Thank you,
Winston
Permalink Submitted by Alan - IRA critic on Tue, 2016-12-13 01:58
I am not familiar with Covered California, but a 72t plan can be set up with an IRA which is partitioned into an account that holds the balance that will generate 20k per year. Very roughly, he would need around 450k in the 72t plan IRA account to produce a 20k annual distribution. The 72t plan would be a 5 year plan which terminates 5 years after the date of the first distribution. He must distribute 60 months worth of distributions in total (100k). He cannot make contributions or additional distributions from the IRA or the plan is busted and he would owe retroactive penalty and interest back to the first distribution. If he has more in his IRA than 450k, the other IRA account would not be part of the 72t plan and he could use it for emergency needs and take distributions from that other IRA that would not bust his plan. If he has less than 450k total in his IRAs, then he will not generate the 20k distribution he needs.
Permalink Submitted by David Mertz on Tue, 2016-12-13 17:56
If the 401(k) plan is provided by the employer from which the client will be separating from service on December 31, distributions from the 401(k) will already qualify for the age-55 penalty exception for distributions from a qualified retirement plan, no need for a 72(t) plan. Assuming no losses due to poor investment performance, the 401(k) has sufficient assets to make distributions of $20,000 per year without exhausting the 401(k) before age 59½. If the 401(k) is rolled over to an IRA, the age-55 exception will be lost.
Permalink Submitted by Alan - IRA critic on Tue, 2016-12-13 18:31
Yes, I overlooked the separation age here. However, some plans do not allow flexible distributions and if client were to distribute 3-4 years worth of expenses, he could spike his marginal rate for the distribution year. If he happened to go from the 15 to the 25 bracket, that 10 points would erase the benefit of the penalty waiver. If the plan only allows an unacceptable distribution option, then an IRA rollover and 72t plan might be the most logical solution remaining despite normally being a last resort due to it’s rigidity and risks. If the 72t is necessary, the plan balance should be rolled over to an IRA and the plan executed from the IRA. While it is legal to have a 72t plan directly from the 401k, the taxpayer has reduced control of the plan compared to an IRA because the plan administrator has control of the 401k plan and could undertake transactions that might bust the plan. So check into the distribution options for the 401k plan for retirees. NUA should normally be considered, but the taxable cost basis might not fit with the covered CA situation.