Early Withdrawal (Pre 59-½) Penalty Tax Exceptions and Annuities

We receive questions regarding possible exceptions to the 10% additional penalty tax on pre-59½ distributions from Qualified Plans, IRA's and non-qualified deferred annuities. Below is a quick reference guide.

1. Qualified Plan Distributions

IRS Publication 575 (Pensions and Annuity Income) defines a qualified plan as one of the following:

• (a) Qualified employee retirement plan [including qualified cash or deferred arrangements (CODA's) under section 401(k)]
• (b) A qualified annuity plan
• (c) A tax sheltered annuity plan for employees of public schools or tax-exempt organizations
• (d) An individual retirement arrangement (IRA)

If payments begin from a qualified plan after an employee has separated from service [IRC Section 72(t)(3)(B)] then the 10% penalty does not apply if the distributions are either:

• Part of a series of substantially equal periodic payments ("SEPPs") not less frequently than annually, made for the life or life expectancy of the employee or the joint lives (or joint life expectancies) of such employees and his designated beneficiary [IRC Section 72(t)(2)(iv)]. The Payments under this exception must continue for at least 5 years or until taxpayer reaches age 59½, whichever is the longer period. If the payments under this exception are changed before the end of the required periods for any reason other than the death or disability of the owner, he or she will be subject to the 10% additional tax.
• Made after separation from service if separation occurred during or after the calendar year in which taxpayer attained age 55
• Paid to alternate payees under a qualified domestic relations order (QDROs)
• Paid to taxpayer to the extent there are deductible expenses for medical care (the amount that exceed 7½% of AGI), whether or not deductions are itemized
• Paid on account of death or total and permanent disability

2. IRA Distributions

Pre-59½ distributions from an IRA can avoid a 10% penalty tax if they are:

• Received under the "SEPP" exception as described earlier
• Paid to the IRA owner's total and permanent disability
• Paid to a beneficiary or to the IRA owner's estate after the death of the IRA owner

3. Non-Qualified Annuity Distributions

Pre-59½ distributions from a non-qualified annuity may be excepted from a penalty when they are paid under an immediate annuity contract. Immediate annuity is defined per IRC Section 72(u)(4) as purchased with a single premium or annuity consideration, the annuity starting date commences no later than 1 year the date of the purchase of the annuity, and it provides for a -series of substantially equal periodic payments (to be made not less frequently than annually) during the annuity period.

(Note: Rev. Rul. 92-95, 1992-2 CB43. Where a deferred annuity contract was exchanged for an immediate annuity contract, the purchase date of the new contract for purposes of the 10% penalty tax was considered to be the date the previous deferred annuity was purchased. Thus, payments from the replacement contract did not fall within the immediate annuity exception to the penalty tax.)

Other non-qualified annuity exceptions are for distribution which are either:

• Allocable to the cost or basis portion of a deferred annuity contract issued before August 14, 1982
• Paid from an annuity contract under a qualified personal injury settlement (so called "structured settlement")
• Paid under a deferred annuity contract purchased by an employer upon the termination of a qualified employee retirement plan or qualified annuity and that is held by the employer until the taxpayer separates from the service of the employer

Adapted from Technically Speaking, No. 95-1, Jan 23, 1995; published by Canada Life Assurance Co. Author: Robert Hoffman, ChFC, CLU.