The answer to this is not entirely clear. The IRS has busted a couple of 72t plans for partial transfers to another IRA. While the IRS has not been able to provide a rational explanation for the main ruling, this does create some risk. In addition, the more moving parts there is to a 72t plan, the more likely the IRS will look into it.

The main letter ruling is PLR 2007 20023. While this and another less direct ruling are the only ones to date, while thousands of such partial transfers have gone unscathed, it is obvious that the risk to this client is minimal, and likely smaller than the risk of making an execution or calcalution error would be. Still, I would disclose this situation to the client and let the client decide if they want to proceed.

The client would also reduce the risk here if the SEPP distributions could continue from just the original IRA account. Everything would look normal to the IRS and there would only be one 1099R to report. The IRA custodian will not provide the exception coding on that 1099R (code 2), but probably does not provide it anyway. The exception can be claimed on Form 5329 if the custodian does not provide the coding.

I think taking the distributions from all 3 accounts probably creates a larger risk than the partial transfer itself due to coordination risks and 1099R forms that have to add up to the exact dollar amount reported in prior years.

Finally, if he is going to still proceed with the partial transfers, they should be done by direct non reportable transfer only rather than by rollover. An indirect rollover would produce larger amounts on the 1099R forms and a 5498 for each rollover and that would send up a big red flag about the partial transfer.

Here is additional detail about PLR 2007 20023:
http://www.72t.net/Articles/Articleshow.aspx?WA=ca625daf-c846-41a4-a730-…

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The whole 72t arena is tough. The IRS could help if they issued some Regs instead of expecting the tax community to decipher two decades worth of private letter rulings and an occasional tax court decision on the matter. There is not even great consistency in the letter rulings as noted in the PLR cited earlier. Along with the limited guidance, most IRS inquiries into current plans show little understanding of 72t plans. That leaves us operating under some combination of what the IRS had indicated in the past along with their actual enforcement efforts over time.

That is why these plans, while potentially very useful, are still best avoided except as a last resort. And when utilized, they should be as simple and unobtrusive as possible to avoid attracting IRS attention to them.

It is interesting to note that almost all major IRA custodians have stopped “underwriting” the validity of these plans by providing the exception 1099R coding. Most taxpayers must now claim their own exception by attaching Form 5329 every year.

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Divorce situations are one of the circumstances for which the IRS has issued conflicting letter rulings. Accordingly, divorce settlements are best structured to leave any existing SEPP plans in place, avoiding any transfer incident to divorce for the actual SEPP IRA account, and settling up using other assets. The QDRO penalty exception does not apply to IRA accounts.

These ruling have resulted in the situation where it is impossible to know with any confidence whether the IRS will:
1) Require each spouse to complete the SEPP plan in accord with the % split of the IRA
2) Require only the original spouse to complete the plan despite a greatly reduced account balance due to the partial transfer
3) Allow the original spouse to scale down the distribution in accord with the transfer regardless of what the other spouse distributes

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