Education expenses and 72(t) plans

Individual retirement account owners under 59½ who take a distribution from their IRA are subject to a 10% penalty on the taxable amount of the distribution. But there are several exceptions to the penalty.

For example, IRA owners with a continuing need for funds from the account to pay everyday living expenses can set up a 72(t) payment plan, named for the tax code section that governs these distributions. The tax code refers to these as a series of substantially equal periodic payments.

The IRS has three approved methods for calculating 72(t) payments: the required minimum distribution method, the amortization method and the annuity factor method.

Under all three methods, the payments must continue for at least five years or until the account owner reaches 59½, whichever is later. They can be modified only in the case of the death or disability of the IRA owner — or as a one-time switch from the amortization or the annuitization method to the RMD method.

Payments made using these rules aren’t subject to the 10% early distribution penalty.

Let’s look at a recent U.S. Tax Court case that involved a taxpayer who set up a 72(t) payment plan from her IRA.

In 2002, Kim Benz left her em-ployer and elected to receive her distribution once each year, in January. Her distributions under the 72(t) plan weren’t subject to the 10% early distribution penalty.

In 2004, Ms. Benz received her distribution on Jan. 15. In addition, she took another $20,000 in January and $2,500 in December to help pay for her son’s college education expenses.

[More: Can I use IRA to pay for college?]

Distributions for higher-education expenses are an exception to the 10% penalty, but Ms. Benz took these additional funds from an IRA that was already making 72(t) distributions.

She and her husband filed their 2004 tax return on time and re-ported the total amount of her distributions. They also filed Form 5329 (Additional Taxes on Qualified Plans and Other Tax-Favored Accounts) with their return, noting that the IRA distributions weren’t subject to the penalty.

In 2007, the IRS notified Ms. Benz and her husband that the additional distributions taken for education expenses modified her 72(t) payment plan.

It determined that all her distributions for 2004 were subject to the 10% penalty, except for the total paid that year for college expenses — $35,221.50. The additional tax came to $8,959.

Since Ms. Benz and the IRS did not agree on the amount of the additional tax owed, they ended up in Tax Court, which ruled against the IRS and in favor of the couple.

The court found that the wording in the tax code doesn’t prevent the IRA owner from using more than one 10% penalty exception. Each exception will be looked at individually, without regard to other distributions using other exceptions.

The court decision said: “We hold that a distribution that satisfies the statutory exception for higher-education expenses is not a modification of a series of substantially equal periodic payments.”

Amid the tough economy, more retirement plan owners are finding it necessary to tap those funds before retirement. Many are setting up 72(t) payment plans, and some are finding that plans they set up in the past no longer meet their needs.

This court decision points out some of the pitfalls of these plans, principally that payments can’t be modified for most individuals. The consequences of modifying a plan can be severe and ultimately lead to having much less to live on in retirement.

Still, the decision to take distributions may give some account owners much-needed flexibility if they need additional funds for higher-education expenses, medical expenses or medical insurance. Those are the only three exceptions to the penalty that contain the language allowing the use of more than one exception, including a 72(t) payment plan.

The court decision doesn’t mean that the strategy will work from here on in, but it is interesting to know how one court has ruled on this issue. Until we know, for sure, that the IRS will follow this decision in future rulings, the best advice you can give clients is not to modify 72(t) payment plans.

It isn’t recommended that individuals count on this decision to bail them out if they need extra funds. If all possible, it is always a good idea to split an IRA before starting a 72(t) payment plan and keep the second IRA for an emergency cash need.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.