IRA 72t Underpayment of Tax Penalty?
Hello all,
I am looking between the pub 590, the form and instructions for the 5329 and the US Master’s Tax Guide and can’t find an answer:
If after reaching 59.5 but not yet satisfying 5 years someone breaks their 72t, they owe 10% penalty tax on any taxable (pro-rata) portion of the distribution taken prior to 59.5. 1) Is that due for the year the 72t is broken? Or is it due for each prior year a distribution was made (meaning filing 1040-x)? 2) If it was for the prior years, does that mean there was an underpayment of tax and therefor a 20% penalty (on, I am assuming, the taxable portion of the original distribution)? 3) Any other curveballs/caveats to be aware of?
The scenario I am working with is someone who started 72t in 2007 and is 59.5 this year (not sure why they didn’t just do the one time distro, things might have changed since then but am ntot sure). Since taxes are due April 15th (even if have an extension to file) I don’t believe it comes into play but to put it out there, they have a tax extension to October for their 2007 taxes.
Any help and/or resources are appreciated.
Many thanks!
Permalink Submitted by Alan Spross on Thu, 2008-05-22 21:05
1) The retroactive penalty and interest applies to each 72t distribution taken prior to age 59.5 to the day. Stand alone 5329 forms for each year should suffice without a 1040X since the rest of the return is unaffected. The penalty should be paid, but then expect the IRS to bill out interest based on the original due dates. Since this plan only started last year, this will be simplified by just adding the 5329 to the 1040.
2) Underpayment should not apply, just the late interest per above. You are correct, only the taxable amounts are subject to penalty if the IRA had a basis per Form 8606.
There might be some other considerations here. When did they bust the plan. What month in 2007 did it start, and what month this year are they 59.5? Did they bust it because they needed more or wanted to take out less?
Permalink Submitted by Al Fry on Thu, 2008-05-22 21:12
The additional tax (plus interest) is due in the year of modification (IRC Sec. 72(t)(4)(A)(ii)(II)).
Permalink Submitted by michael vee on Fri, 2008-05-23 16:24
Many thanks all!
They plan on busting the plan next month. The reason is because they want less. I am not sure at the moment of the date started or when they turn 59.5 this year. (for my knowledge) Can you explain the different possibilities?
Any and all help is greatly appreciated! Everyone please enjoy the extended weekend!
Permalink Submitted by Alan Spross on Fri, 2008-05-23 22:03
While it is rare that someone starts a 72t that close to age 59.5, there is also a much reduced risk because the retroactive penalty will only apply to the distributions taken prior to age 59.5, and in this case that probably only around one year’s worth.
One option is the one time change to the RMD method that is allowed assuming they used one of the fixed dollar methods. This change could easily knock 40% or more off their annual distribution for the rest of the term of the SEPP and would be effective 1/1/08 so it would effectively reduce the 2008 payout requirement. They would use the 12/31/07 account balance to make the change. This one time change was made available in RR 2002-62 which you can read on this website.
Revisiting the effects of a busted plan, the IRS issued a PLR several years back allowing a taxpayer to voluntarily bust their plan as of year end and start a new plan. If they opted for that, the year of modification would be 2007 and the 5329 for the extended return could include the penalty. Otherwise, by busting the plan this year, they would owe the penalty for 2007 distributions and 2008 distributions prior to turning 59.5.
Therefore. they have two possibilities to reduce the penalty, but the more simple one is the one time switch to the RMD method.