Employee Benefits-IRS Finds That A Transfer Out Of An IRA Results In A Modification To A Series of Substantially Equal Payments Triggering 10% Penalty, While Tax Court Concludes Differently On A Withdrawal to Pay Higher Education Expenses

Section 72(t)(1) of the Internal Revenue Code (the “Code”) imposes a 10% tax on early distributions (the “10% penalty”) from qualified and tax-favored retirement plans, including an IRA. One exception, available under Section 72(t)(2)(A)(iv) of the Code, is that the 10% penalty will not apply to a distribution which is a part of a series of substantially equal periodic payments that:
— are made not less frequently than annually; and — are made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his or her beneficiary.
However, Section 72(t)(4) of the Code provides that, if the series of payments is subsequently modified (other than due to death or disability) before the later of the date on which the employee attains age 59 ½ or the 5th anniversary of the day on which the first payment in the series is made, then generally all payments in the series made before modification become subject to the 10% penalty retroactively. The IRS has provided guidance on the application of the substantially equal payment exception to the 10% penalty, including how to calculate the amount of the payments in the series, in Notice 89-25 and Revenue Ruling 2002-62.

An important issue under the substantially equal payment exception to the 10% penalty is what constitutes a modification. That was the subject of PLR 200925044. In that PLR, the taxpayer had begun taking distributions from her IRA at Company M in a manner which satisfied the substantially equal payment exception. However, to convert a portion of the securities in the IRA into a certificate of deposit, she transferred a portion of her account balance in the IRA at Company M (plus the account balance of her IRA at Company Y) -in a nontaxable trustee- to- trustee transfer- to an IRA at Company Z. The question facing the IRS was whether the transfer out of the IRA at Company M was a modification, and if so whether the modification could be corrected by returning the amount transferred plus earnings from the IRA at Company Z to the IRA at Company M. The taxpayer had not yet reached age 59 ½ or the 5th anniversary of the day on which the IRA distributions had started.

The IRS ruled that a modification had occurred due to the transfer out of the IRA at Company X, and that the modification could not be corrected. In so ruling, the IRS relied on Section 2.02(e) of Revenue Ruling 2002-62, which indicates that a modification will result from a nontaxable transfer of a portion of the IRA’s account balance to another retirement plan, which is exactly what the taxpayer had done.

The Tax Court recently came to a different conclusion on whether a modification had occurred in a different situation. In Benz v. Commissioner of Internal Revenue, 132 T.C. 15 (2009), the taxpayer was receiving distributions from her IRA which satisfied the substantially equal payment exception to the 10% penalty. In addition to the distributions included in the series of payments, the taxpayer withdrew money from her IRA to pay for higher education expenses. Under Section 72 (t)(2)(E), a withdrawal for this purpose is a separate exception to the 10% penalty. The Tax Court ruled that the withdrawal did not result in a modification to the series of payments the taxpayer had been receiving, since there is no reason why two exceptions to the 10% penalty-here the substantially equal payment exception and the exception for a withdrawal to pay higher education expenses-could not apply.

The Tax Court’s holding in Benz probably should not be seen as being at odds with the IRS’s conclusion in PLR 200925044. In Benz, the alleged modification-the withdrawal to pay for higher education expenses-is covered by an express exception in the Code to the 10% penalty. On the other hand, there is no express exception in the Code to the 10% penalty, or to the “no modification” rule, for a nontaxable transfer out of the IRA making the series of payments, and if the transfer is treated as being an exception, a taxpayer could all too easily avoid the “no modification” rule simply by transferring amounts out of the IRA.