Distributions from Traditional IRAs

Distributions from an IRA—whether paid in a lump sum or installments—are taxable under the Section 72 annuity rules. Although taxpayers are free to make withdrawals whenever they want, distributions that occur before age 59½ are subject to tax penalties (unless certain exceptions apply) in addition to the regular income tax. When the IRA owner reaches age 70½, distributions must begin in minimum annual amounts or the owner will incur tax penalties.

Premature Distribution Tax

The premature distribution tax is aimed at taxpayers who withdraw funds before retirement. This rule places a 10% federal tax on the amount of any distributions that occur prior to age 59½, in addition to the regular tax on the distributions. Besides the age 59½ safe harbor, there are other exceptions [IRC Sec. 72(t)] for distributions that—

• occur following the death of the IRA owner;
• occur following the disability of the IRA owner (but not a spouse's or child's disability), disability defined for this purpose as the owner's inability to "engage in any substantial gainful activity by reason of a medically determined physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration" [IRC Sec. 72(m)(7)];
• are part of a series of substantially equal periodic payments made not less frequently than annually, for the life (or life expectancy) of the IRA owner or for the joint lives (or joint life expectancies) of the IRA owner and his/her designated beneficiary;
• are transferred directly or properly rolled over within the 60-day rollover period, so that the distribution is not subject to the regular income tax;
• represent a nontaxable return of the IRA owner's nondeductible contributions;
• are taken by an unemployed IRA owner to pay health-care premiums and do not exceed the amount paid for medical insurance (IRA owner must have received unemployment compensation for at least 12 weeks);
• are taken to pay deductible medical expenses of the IRA owner or a family member and do not exceed the amount deductible under IRC Section 213; i.e., only those medical expenses paid out-of-pocket and not covered by insurance that exceed 7.5% of adjusted gross income;
• are used within 120 days to pay acquisition costs of the first-time principal residence of the IRA owner, spouse, child, grandchild, or parent or grandparent of the IRA owner or spouse (lifetime maximum of $10,000); or
• are used to pay qualified higher education expenses (required tuition, books, fees, equipment, and supplies) of the taxpayer, spouse, child, or dependent grandchild of the taxpayer or spouse.
• are taken from an IRA pursuant to an IRS levy under IRC Sec. 6331.

Remember that if an IRA owner satisfies one of these exceptions, he or she only avoids the 10% penalty on premature distributions, not the regular income tax on the distribution.

With respect to "substantially equal periodic payments," we need to make an important qualification. If an IRA owner has started to take qualifying periodic payments, and later elects to reduce, increase, or halt such payments before age 59½ or within five years of starting, he will trigger the 10% penalty on all payments made before 59½, even if he is over 59½ when he changes the form of payment.

The age-55 exception, whereby a qualified plan participant who has separated from service may take distributions without the 10% penalty after age 55, does not apply to IRA distributions.

Distribution Requirements for Traditional IRAs

If the IRA owner is going to annuitize the payout, distributions may be made as a:

• Life Annuity—monthly payment for life (or life expectancy) to the IRA owner with no further payments to anyone after the individual dies.
• Joint-and-Survivor Annuity—IRA owner receives reduced payments for his or her lifetime and thereafter payments continue to a designated beneficiary (or joint life beneficiaries).
• Period Certain Annuity (a.k.a. fixed-period annuity)—IRA owner (and/or beneficiary) receives payments for a definite period, but not longer than the life expectancy of the IRA owner or joint life expectancies of the owner and the beneficiary.