Once an investor sets up a 72(t) plan, he or she is not allowed to modify it. So somewhat surprisingly, the U.S. Tax Court ruled in May that a 72(t) payment plan was not modified when the IRA holder took an additional distribution for education. Although the IRS sought to assess the 10% early withdrawal penalty, the Court ruled in favor of the taxpayer, Kim Benz, stating that the extra distribution did not trigger the 10% penalty.

This decision may give IRA owners some much-needed flexibility if they need more funds for certain purposes. But only time will tell if the IRS will follow the Tax Court's lead.

HOW 72(T) PLANS WORK

A 72(t) plan allows retirement plan owners younger than 591/2 to tap their accounts without the 10% early withdrawal penalty, which has been happening more often in these uncertain economic times. If the IRA owner has an ongoing need for IRA funds, for example, to pay everyday living expenses, then he or she can set up a 72(t) payment plan, which the tax code refers to as a series of substantially equal periodic payments. A 72(t) plan can be used with IRA, 401(k), 403(b), TSA and 457 plans.

The IRS has three approved methods for calculating these payments:

• * The required minimum distribution (RMD) method;
• * The amortization method; and
• * The annuity factor method.

The RMD method is calculated the same way RMDs are calculated at age 701/2, using the account owner's age each year and a current account balance. This produces a different payout amount each year. The other two methods-amortization and annuitization-produce equal payments each year.

The payments under all three methods must continue for at least five years or until the account owner reaches age 591/2, whichever is longer. They can only be modified in the case of death or disability (or a one-time switch from the amortization or annuitization methods to the RMD method). Payments made using these rules are not subject to the 10% early distribution penalty.

For example, assume Jeffrey sets up a 72(t) plan when he is 52. He must continue taking substantially equal payments from his IRA for 71/2 years, until he reaches age 591/2. On the other hand, Anna sets up a 72(t) plan when she is 57. She must continue taking substantially equal payments from her IRA for five years, until she reaches age 62.

In order to qualify for the exception to the 10% penalty, IRA owners cannot change the account balance except by making the required distributions and through account earnings and losses. They cannot add other retirement funds or contributions to the account or take distributions in excess of the 72(t) calculated amount. Violating this rule will terminate the 72(t) plan and assess the recapture tax. All distributions made under the plan prior to the account owner reaching age 591/2 become subject to the 10% penalty, plus interest.

Jeffrey, who set up a 72(t) plan when he was 52, must take substantially equal payments from his IRA until he reaches age 591/2. If at 55 he takes an extra distribution that does not qualify for any other exception, all of his distributions since age 52 will be subject to the 10% penalty plus interest.

Anna set up a 72(t) plan when she was 57. She must take substantially equal payments from her IRA until she reaches age 62. If at 61 she takes an extra distribution that does not qualify for any other exception, all of her distributions from age 57 through age 591/2 will be subject to the 10% penalty plus interest.

In addition to the 72(t) payment plan exception, there are some other exceptions to the 10% early withdrawal penalty for IRAs only:

• * Distributions for first-time home buyers (lifetime cap at $10,000);
• * Distributions for qualified higher education expenses; and
• * Distributions for the cost of the taxpayer's medical insurance, if certain conditions are met.

Now, assume that your client is younger than 591/2. If he takes a distribution in a year that he pays any one of those expenses, he will not have to pay the 10% early distribution penalty up to the amount of his expense.

THE KIM BENZ CASE

In 2002, Kim Benz left her employer. She then set up a 72(t) payment plan from her IRA. She elected to receive her distribution once each year, in January.

In 2004, Kim received her distribution on January 15. In addition, she took another $20,000 in January and $2,500 in December to pay for her son's college education expenses. Distributions for higher education expenses are an exception to the 10% penalty, but Kim took these additional funds from an IRA that was already making 72(t) distributions.