avoiding 10% early penalty from pension converted to IRA R/O

Submitted by Catherine Turner on Thu, 2012-06-21 16:46

I had the understanding that if an employee of a company who accepted an official “early retirement package that included severance pay” under the age of 59.5, but age 55+, and took a withdrawal out of their 401(k) plan (which remained with the employer for the time being) that the Ex-employee would NOT face any 10% penalty. This would also apply if they were to being receiving a lifetime annuity payout from a pension benefit after having attained age 55 and before attaining age 59.5.
My question is this: what if the employee was NOT prompted by the employer to take an “early retirement package that included severance pay” , and the employee was age 57 and chose to retire early just because, and the employee chose a lump sum pension benefit that allowed immediate access and rolled the proceeds into an IRA? Their employer is telling them that if they keep the dollars in a separate IRA that they can pull out at age 57 penalty free. What comments can you offer?



Submitted by Alan Spross on Thu, 2012-06-21 17:12

The employer is incorrect. See the 5th exception on the IRS penalty exception chart here:

http://www.irs.gov/pub/irs-tege/early_distributions.pdf

If the 57 year old separating employee takes a distribution directly from the plan, there is no penalty. But for amounts rolled over to an IRA and then distributed from the IRA, the penalty will apply until age 59.5. It does not matter if the IRA is a separate rollover IRA or not.

The solution for many who have done IRA rollovers and then need funds prior to 59.5 is to establish a 72t (SEPP) plan. For those separating prior the year they reach 55, the option of penalty free distributions from the plan does not exist, and for those separating at 55 or later the exception will apply. However, the practical use of this exception is often limited to plans that allow periodic or flexible distributions through age 59.5. If the plan requires a lump sum distribution, the portion the employee does not roll over may increase their marginal rate as much or more than the 10% penalty they are avoiding. That results in some that separate at 55 having to set up a SEPP as well. A 57 year old should try to avoid the SEPP if possible because the SEPP plan must last 5 years while the taxpayer only needs two years of expenses before reaching 59.5.



Submitted by Catherine Turner on Thu, 2012-06-21 18:39

Alan – I noted that you did not make any comments about employees taking a formal “early retirement package that included severance pay” under the age of 59.5, but age 55+. I saw the attached link to the IRS , and the form did not make any specific side notation regarding the reasons attached to the severing of employment at age 55. I have always held the understanding that an employee who did accept a formal offer from a company employer for “early retirement package that included severance pay” under the age of 59.5, but age 55+, could take random withdrawals out of their employer’s qualified deferred comp
401(k) plan that were exempt from the 10% penalty, BUT, if someone decided to retire on their own volition, with NO severance pay, NO formal retirement package, that they would be subject to the 10% penalty – simply because they were under the age of 59.5. Maybe I am incorrect; this is why I was asking you.

Could be just what is says…..it doesn’t matter how or why a 55 year old has severed their employment, they can take random withdrawals out of their “old”
401(k) facing the 10% penalty. My client is not being offered a “formal early retirement package with severance pay”.

I am in agreement with you regarding taking withdrawals out of a lump sum pension benefit “rolled over” into an IRA and taking withdrawals prior to 59.5.
My client would not benefit doing a 72-T SEPP.



Submitted by Alan Spross on Thu, 2012-06-21 20:22

Receipt of severance pay including the rollout paychecks to age 55 is immaterial to determination of the date of separation from service. In fact, severance pay cannot commence until separation from service has occurred. Therefore, separation without any severance benefit is considered the same as separation with a severance payment.

It’s a good question though, since in a rollout severance the pension plan considers that you worked until 55, so if you were working then perhaps you are not considered separated. However, the IRS does not link pension qualification to extension of the date of separation with respect to Sec 72t. Therefore, your client should not think that if he had been offered a severance plan, it would have mitigated the penalty in any way.

Finally, note that the early distribution penalty only applies to qualified plan distributions. Most deferred comp plans are non qualified, ie a 457b plan. Since these plans are not qualified plans, there is no early withdrawal penalty. If the client has money in such a plan, his distributions would be penalty free regardless of age.



Submitted by Thomas perry on Thu, 2012-06-28 19:42

Your Thoughts….

I am 51 yrs old and i am seperating from service with a lump sum of 700k along with 400k in a 401k. The combined 1.1 million at the 1.57 June Fed mid term rate will allow me to withdraw 42k per year. My plan is to put the lump sum into a variable annuity with a GMIB compounding at 5% for income and use the 400k from 401k as my 72t account while the annuity is still compounding @ 5%. What i do not like is the fact that i may use up all my liquid funds by the time i reach 59.5. I do have access to 10% plus any gains per year from annuity.

your thoughts



Submitted by Alan Spross on Thu, 2012-06-28 20:00

See other post.



Submitted by Ed Fleck on Thu, 2012-07-12 14:23

I have been taking $2,040.25 per month out of my IRA since 1/1/2009 via a SEPP plan. I used the Life Expectancy Calculation based on my single life expectancy, with a actual balance of $464,553.

I turned age 59 1/2 on October 6, 2010. My current balance is $518,000. To date I have received 43 monthly payments for a total of $87,730.75. Total distributions from 1/1/2009 until I attained age 59 1/12 is 22 x $2,040.25 = $44,885.50.

Having been unemployed since 10/1/2011 I now need to take a non-periodic distribution out of this IRA for the amount of $60,000. Here are a few questions that I have:

1) Can I avoid paying the recapture excise tax and interest (I understand called a busted SEPP) by keeping the SEPP IRA and executing a direct transfer to a new IRA of the excess over what I need to complete the SEPP? (17 payments x $2,040.25 = $34,684.25). DIrect transfer amount about $483,000.

2) If not, are there any hardship exceptions that I can use to take the $60,000? Such as son’s education expenses or unreimbursed medical expenses.

3) If not, will the tax and interest that I owe be based only on the distributions that I received from 1/1/2009 until 10/6/2010 (date I attained age 59 1/2)

Thanks in advance for your insights!



Submitted by mk foss on Thu, 2012-07-12 17:38

To avoid the 10% penalty using SEPP you must take payments for the greater of 5 years or attaining age 59-1/2. Since you started so close to 59-1/2, you need 5 years to avoid penalties. The 5 year period starts on the date of the first withdrawal – January 2009. Since you started the SEPP any withdrawals in addition to the SEPP payments will “bust” the plan and cause you to pay penalties for 2009-2011 withdrawals plus interest. You could avoid the 10% penalty for 2012 by using the higher education exception; you just need to spend as much in 2012 as you pay out for qualifying higher education.

One taxpayer used the higher education exception and was allowed to keep the SEPP in place but he/she had to go to the Tax Court to get that treatment. IRS did not allow it.

There are no hardship exceptions. Usually an advisor will tell you not to use all of your IRA balance for the SEPP. If you kept a separate IRA not involved in the SEPP – you could tap it for other exceptions (like higher education) or just pay a penalty on one distribution.



Submitted by Alan Spross on Thu, 2012-07-12 17:57

1) No, a transfer or rollover to another retirement plan (eg another IRA account outside the plan) would itself bust the plan.

2) There was a PLR (Benz vrs IRS) that allowed a SEPP participant to take out the extra amount needed to pay a qualified higher education expense without busting the plan. I doubt that you could rely on this without getting your own PLR and pursuing your own PLR would cost around 10k plus legal costs. That is much more than the busted SEPP penalty. This is the only such PLR to my knowledge and there is none for medical costs.

3) That is correct. Your retroactive penalty ONLY applies to distributions you took prior to age 59.5 ($4,489 plus interest). However, if you have other penalty exceptions eg. 2009 or 2010 higher education or high medical costs, you could file amended 5329 forms for 2009 and 2010 to offset some of that penalty. IRS would bill interest only on the amount of the penalty remaining.

Any chance you could get a short term loan for the extra amount? Since your plan ends 5 years after the date of your first payment (sometime in Jan, 2014), you only need an 18 month loan to avoid busting the plan.

Otherwise, you would report a volutarily busted plan on Form 5329 with your 2012 return and that would serve to end your plan this year and remove any further restrictions. You would just report the penalty amount on Form 5329 as there is no way to figure the interest. IRS would probably bill the interest later.



Submitted by Ed Fleck on Thu, 2012-07-12 20:12

Thanks for confirming my understanding of the provision. I did not have either hardship exception occur in 2009 or 2010.

I do have two follow-up questions on the actual 5 year start and end dates. I did not start the SEPP until 7/1/2009. My advisor’s BD Commonwealth Equity directed me to take double the required monthly distribution as I had to take the entire required annual amount of $24,483 out during the remainder of 2009. So I took 6 equal payments of $4,161.00 by the end of 2009. Then in 2010 I started receiving the normal monthly amount of $2,040.25 and have consistently taken this every month through July 2012.

And I paid a total of $24,483 in 2010, 2011 and will also in 2012.

My first question: does my 5 year period start on 7/1/2009 when I started taking distributions or is the start date back dated to 1/1/2009?

My second question is, based on the answer to question 1, does my obligation end:

1) In December 2013, the date that I will have received a total of five times my annual required distribution of $24,483 ($122,415)

2) or do I have to continue paying through 6/30/2014 (in which case I will have over distributed by 6 x 2040.25)

Thanks!



Submitted by Alan Spross on Thu, 2012-07-12 20:55

Your 5 year period begins on the date of the first actual distribution (7/1). That means your SEPP modification date would be 7/1/2014, not 1/1/2014. Any distribution not qualifying as a SEPP distribution before that date would bust the plan.

However, since you will have taken out 60 monthly payments by the end of 2013, you do not have to take out any more. Between 1/1/2014 and 7/1/2014 you have 3 options:
1) Take out nothing
2) Take out 6 months worth
3) Take out a full annual amount

The reason for the 3 options is that each of them would be an allowed SEPP distribution under your circumstances. If you had only taken out 6 months worth in 2009, then Option 1 would be eliminated since you need 60 months worth as a minimum. The only thing you could not do is take out a different amount than any of the above 3 options. After 7/1/2014 you could do anything you wish.

Of course, all of this is moot if you bust the plan first. If you take out more than 24,483 in any year, the plan ends there. And since you are over 59.5, there is no reason to start a new plan.



Submitted by Ed Fleck on Fri, 2012-07-13 02:50

THANKS VERY MUCH Alan

I am a bit surprised about option 3. Wouldn’t that bust my SEPP since will be taking out more than 5 years times $24,483.

Also, I just need to find a way to stay the course until 1/1/2014 at which time I can immediately take another $24,483.

Best regards,

Tom Fleck



Submitted by Alan Spross on Fri, 2012-07-13 03:40

3 would be OK because these are basically calendar year plans and the full annual amount is what you have been taking all along. The IRS has been quite flexible with the final year as long as you do not take out an amount before the plan modification date that is inconsistent with your earlier annual distributions. -0- is also OK because you have already met the 60 months minimum and the plan is over before 2014 is over.



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