06/01/2007 E-alert – Planning for Retirement Assets Requires Special Care – Bad Advice by Financial Planner Causes Tax Penalty to Client

In Private Letter Ruling 200720023 the Internal Revenue Service ruled that two trustee-to-trustee transfers performed at the advice of the taxpayer’s financial advisor caused a 10% premature withdrawal penalty – even though the taxpayer was taking distributions as part of a series of equal periodic payments (“SEPP”) and the taxpayer attempted to correct the error by transferring the funds back into the IRA from which they were originally transferred. The Private Letter Ruling is silent as to the dollar amount of the IRA transfers, but it is likely that this mistake cost the taxpayer tens, perhaps hundreds, of thousands of dollars of unnecessary penalties– and that the financial planner will be required to reimburse the taxpayers for these penalties, as well as the cost of requesting the unsuccessful PLR from the IRS.

A taxpayer under the age of 59½ needed to take withdrawals from his IRA. Normally, a withdrawal from an IRA by a taxpayer under age 59½ would be subject to a 10% penalty under Internal Revenue Code Section 72(t)(1). However, there are several exceptions to this penalty – a few of which are: (1) a withdrawal because of the taxpayer’s disability; (2) a withdrawal to pay for medical expenses (limited to the amount reported on Schedule A of the 1040); (3) distributions made to a beneficiary as the result of the death of the IRA owner; (4) under certain circumstances, distributions resulting from normal retirement after age 55; and (5) distributions taken as SEPP withdrawals as described by Internal Revenue Code Section 72(t)(4). Here, the taxpayer desired to avoid any penalties and was taking SEPP withdrawals.

After the SEPP payments had begun, the taxpayer made two trustee-to-trustee transfers from his existing IRA to a newly established IRA. The taxpayer informed the IRS these transfers were made on the advice of his financial planner that the taxpayer needed to diversify his investments. The taxpayer took no withdrawals from the newly established IRA – he continued to take his SEPPs from the original IRA.

The IRS, as a result of an audit, imposed a 10% penalty on the SEPPs. The taxpayer tried to correct the situation by transferring the funds back to the original IRA and requesting an abatement of the penalty in his PLR. The IRS ruled that relief was not available. The IRS noted that Internal Revenue Code Section 72(t)(2)(A)(iv) provides that Code Section 72(t)(1) shall not apply to SEPP distributions made for the life (or life expectancy) of the IRA owner or joint lives (or joint life expectancies) of the IRA owner and his designated beneficiary.

Furthermore, Code Section 72(t)(4) imposes a limitation on distributions excepted from the 10% penalty by Code Section 72(t)(2)(A)(iv). If the series of payments is subsequently modified (other than by reason of death or disability) (1) before the close of the five year period beginning with the date of the first payment and after the retirement plan owner attains age 59½, or (2) before the retirement plan owner’s attainment of age 59½, then the retirement plan owner’s tax for the first taxable year in which such modification occurs shall be increased by an amount, determined under regulations, equal to the tax that would have been imposed except for the exception under Code Section 72(t)(2)(A)(iv), plus interest for the deferral period.

Finally, the IRS noted that Section 2.02(e) of Revenue Ruling 2002-62 provides that under all three methods, substantially equal periodic payments are calculated with respect to an account balance as of the first valuation date selected in section 2.02(d). Thus, a modification to the series of payments will occur if, after such date, there is (i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.

In this case, the taxpayer began receiving his SEPP payments from his original IRA in 1999 in an amount calculated using the fixed annuity method described in Notice 89-25. In 1999 and 2000 the taxpayer engaged in trustee-to-trustee transfers from his original IRA to a second IRA for investment diversification purposes. These transfers occurred prior to the end of the period described in Code Section 72(t)(4).

Based on the above facts and representations, the IRS determined that, in calendar years 1999 and 2000, the trustee-to-trustee transfers constituted modifications to the SEPP distributions that the taxpayer began to receive from his original IRA during 1999. As a result, the IRS concluded that the trustee-to-trustee transfer constituted a “modification to a series of substantially equal periodic payments” as described in Internal Revenue Code Section 72(t)(4), resulting in the imposition of the 10% penalty.

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