by Denise Appleby CISP, CRC, CRPS, CRSP, APA
(click here [above] for a copy of the summary opinion)
The US Tax Court issued a summary opinion, in which they held that an amount withdrawn from an IRA that is earmarked for a substantially equally periodic payment (SEPP) program, does not result in a modification if the amount qualifies for another exception under IRC § 72(t). This decision surprised many tax and retirement planning professionals, as previously they have always understood from available guidance that the only distributions that could occur from such an account without causing a modification was a SEPP.
Retirement account owners are subject to a 10% excise tax ( early distribution penalty) on amounts withdrawn from their tax-deferred or tax-free retirement accounts before they reach the age of 59 ½, unless an exception applies. One of these exceptions is distributions made under a SEPP program. SEPPs are subject to a strict set of rules, including disallowing distributions that are more or less than the calculated SEPP amount. Generally if an individual withdraws more or less than the SEPP amount, it results in a modification which disqualifies the SEPP and the individual is required to pay the IRS the penalties that were waived under the program plus interest. For an explanation of the 72(t) rules, see the article Substantially Equal Periodic Payments (A Doorway to Penalty Free Distributions)
The Tax Court Case
What The Taxpayer Did
The taxpayer started a SEPP in 2002, which means the SEPP had to continue for five years or until she reached age 59 ½, whichever is longer. The SEPP amount was $102,311.50 to be distributed from her IRA on January 15 each year for the duration of the SEPP program. In January of 2004, she took the SEPP distribution of $102,311.50. However, she also took additional distributions of $22,500 during 2004, which qualified for an exception to the penalty because it was used to pay for qualified education expenses. She was under age 59 ½ when these distributions were made.
The total amount that she spent for qualified education expenses for the year was $35,221.50.
When she (timely) filed her 2004 tax return, she reported $124,811.50 ($102,311.50 + $22,500) in IRA distributions for the year. She filed IRS Form 5329 to claim the exception to the penalty, and as such, did not include the penalty as payment to the IRS.
What the IRS Said
On June 22, 2007, the IRS issued a notice of deficiency to the taxpayer for Federal income tax in the amount of $8,959. According to the IRS, a taxpayer who starts a SEPP is not allowed any further distributions during the SEPP period, irrespective of whether the distribution would qualify for another statutory exception under Section 72(t) of the tax code unless the employee dies or becomes disabled.
The IRS determined that $89,590 of the $124,811.50 was subject to the 10% early distribution penalty ($102,311.50 –35,221.50), because the SEPP was modified. As a result of the modification, only the amount used to cover higher education expenses was eligible for the waiver of the penalty.
What the Tax Court Said
The Tax Court disagreed with the IRS and provided several references and explanations in coming to its decision. These include the following:
- By specifically creating an exception for distributions used for higher education expenses, Congress recognized that “it is appropriate and important to allow individuals to withdraw amounts from their IRAs for purposes of paying higher education expenses without incurring an additional 10-percent early distribution tax.”
- Distributions for qualified higher education expenses serve one of numerous purposes Congress identified as deserving special treatment.
- Had the additional distribution of $22,500 not qualified for an exception to the penalty under IRC §72(t), it would have resulted in a modification of the SEPP.
- The last sentence of IRC §72(t)(2)(E) recognizes that an employee may qualify for more than one statutory exception to the 10-percent additional tax. It provides that the amount of distributions attributable to higher education expenses does not take certain distributions into account when determining whether the distribution is eligible for the exception to the penalty. These distributions include SEPPs, distributions for eligible medical expenses, distributions due to a qualified domestic relations order, and distributions to unemployed individuals for health insurance premiums.
- The method of calculating the taxpayer’s SEPP amounts will not change as a result of the additional distributions.
- Congress enacted the recapture tax under section IRC §72(t)(4) to apply to prior distributions received under a SEPP , where the taxpayer fails to adhere to the payment schedule elected for the SEPP period.
- There is no indication that Congress intended to disallow all additional distributions within the SEPP period.
- The legislative purpose of the 10-percent additional tax under section 72(t) is that “Premature distributions from IRAs frustrate the intention of saving for retirement, and section 72(t) discourages this from happening.” This legislative purpose is not frustrated where a taxpayer receives distributions for more than one of the purposes that Congress has recognized as deserving special treatment.
Based on these reasons, the Tax Court held that a distribution that satisfies the statutory exception for higher education expenses is not a modification of the SEPP.
We already know discontinuation of the SEPP as a result of the taxpayer being disabled or deceased does not result in a modification. If we follow the logic in this summary opinion, a modification also does not occur if distributions are taken for any of the other exceptions under IRC§ 72(t). The question now becomes: What should taxpayers do when faced with a decision of whether to take additional amounts from a retirement account that is under a SEPP program? The best approach would be to consult with a tax-professional, financial professional or retirement counselor who is proficient in the area of SEPPs. This summary opinion is not law, and cannot be treated as precedence for any other case; as such, no one should take action based on this summary opinion.
Some of the SEPP experts who have examined this case feel that the IRS’ position is correct; They also feel that the IRS may retest this issue and there is a strong possibility that the outcome may be different if the matter is revisited. A few of these experts feel that the Tax Court’s position is correct, and that their explanations provided some much needed clarity on an area of confusion.
For information about SEPPs, SEPP calculators and to view or participate in discussions with the leading SEPP experts, visit www.72t.net
 IRC § 72(t) is the section of the tax code , under which a list of exceptions to the 10% early distribution penalty is provided
 Even though $22,500 was distributed specifically for higher education expenses, the taxpayer used $12,721.5 of the SEPP funds to also cover those expenses ($35,221.5- $22.500). Or, she could have used other funds. The actual source of the funds is irrelevant. What is relevant is that she took distributions and those distributions were enough to cover those higher education expenses.
H. Rept. 105-148, at 330 (1997), 1997-4 (Vol. 1) C.B. 319, 652.
Arnold v. Commissioner, 111 T.C. 250, 255-256 (1998)
Dwyer v. Commissioner, 106 T.C. 337, 340 (1996) (citing S. Rept. 93-383, at 134 (1973), 1974-3 C.B. (Supp.) 80, 213)