Make sure 72(t) distributions are taken

In a recent private-letter ruling, the Internal Revenue Service allowed a woman to make up a missed 72(t) distribution that wasn’t taken because the custodian’s employee handling the distribution retired before setting the client’s distribution. The employee’s retirement botched the client’s retirement!

The taxpayer took a “makeup” distribution to cover the shortfall, and the IRS saved the day by ruling that no modification occurred. But this was an expensive mistake.

So-called 72(t) distributions, are a way to tap your IRA before 591/2 without a 10% early-withdrawal penalty. Individuals must commit to a plan of withdrawals according to the rules set out in Section 72(t)(2)(A)(iv) of the Internal Revenue Code.

To qualify for the exemption from the 10% penalty, the 72(t) payments must continue for five years or until an individual reaches 591/2, whichever is longer. Once the taxpayer commits to a schedule of 72(t) payments from an individual retirement account, he or she must continue with the chosen payment schedule until the end of the term is reached.

During the payment period, the withdrawals can’t be changed. Other than certain exceptions, payments can’t be missed, increased or decreased, or a “modification” occurs.

If the 72(t) payment schedule is modified, an individual no longer qualifies for the exemption from the 10% penalty, and the penalty is reinstated retroactively to all distributions taken prior to 591/2. That can be an expensive mistake.

In this case, a woman had set up a 72(t) distribution payment schedule from her IRA using the fixed amortization method. She received these distributions for several years with no problem.

An employee with the custodian that held the IRA was assigned to make the annual distributions. The employee sent the client her annual distributions each year without communicating with the client or requiring the client’s consent.

Apparently, the 72(t) withdrawals were set up as an automatic payout to the client, which was fine.

However, in 2011, the employee who had been handling the distributions for years retired before making the mandatory withdrawal for that year. She didn’t transfer her responsibility for making the client’s annual payment to another employee.

As a result, the custodian erroneously failed to distribute the 72(t) payment for 2011.

That missed 72(t) payment modified the woman’s payment schedule and placed her in violation of IRS rules. This missed payment could have caused all of her prior years’ distributions to be subject to the 10% penalty, plus interest.

The client didn’t know that the employee had retired and didn’t realize that a 72(t) payment was missed until she received her 2011 Form 1099-R in January 2012. She immediately noticed the error and contacted the custodian, who sent her a letter acknowledging that its error resulted in the missed payment.

The client then took a makeup distribution in 2012 for the missed 2011 amount. Because she had to take a distribution for 2012 as well, she ended up receiving more than the annual distribution amount that year.

She requested a private-letter ruling from the IRS stating that her failure to take a 72(t) payment followed by the makeup distribution the next year wasn’t a modification of the 72(t) payment method. She represented that she didn’t intend to modify the payments and would continue to use the fixed amortization method.

The IRS fee alone to request this ruling was $10,000.

FAVORABLE RULING

The IRS ruled that she didn’t modify the 72(t) series of payments.

Accordingly, the 10% early-distribution penalty was avoided and she can continue taking penalty-free 72(t) withdrawals. The IRS certainly was influenced by the fact that the custodian acknowledged its error in failing to make the 2011 distribution.

In other private-letter rulings, the IRS also has held that when the custodian paid out the wrong amount and then made an offsetting makeup distribution to fix the mistake, the 72(t) payments weren’t modified.

But in this case, it cost the client a $10,000 IRS fee plus any professional fees for preparing the case and submitting the request to the IRS. These costs can be prohibitive for clients and can’t be good for advisers or financial institutions that caused the mistakes.

Advisers should check that clients take their 72(t) payments each year as part of year-end checklists, and avoid expensive and embarrassing problems such as this.

Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group.