Use of Annuities — IRC 72(q) versus

L1: Use of Annuities — IRC 72(q) versus Allow me to take a stab at clarifying this whole issue of using annuities versus traditional debt/equity instruments as part of a 72(q)/72(t) substantially equal periodic payment (“SEPP”) plan. In general, but only in general, IRC 72(t) governs SEPP plans that originate from defined contribution plans (401(a)’s, 401(k)’s, 403(b)’s) as well as IRAs. In parallel (most of the time) with 72(t) is IRC 72(q) which governs SEPP plans originating from defined benefit plans as well as annuities. With this in mind, let’s assume John, aged 55 in 2004 with an IRA with exactly $1,000,000. Further, John wants to commence SEPP distributions in January, 2004. Using Rev. Rule 2002-62, we learn that the maximum interest assumption available to John is 4.26%. John has a life expectancy of 29.6 years. Drop these numbers into the amortization hopper & we get $60,075 per year as the SEPP distribution. This is the maximum allowed as of right now under 72(t). Now, how does John go about structuring his investments to theoretically achieve two separate objectives: (a) create $60,075 in cash each year for the distributions; (b) maintain & hopefully grow the IRA balance above and beyond the $1,000,000? In this regard, John has a couple of distinct choices:
(1) John purchases $1mm worth of GM bonds @ 7.5%, thus generating $75,000 in cash deposited into his IRA of which he distributes $60,075 each year & reinvests the extra $14,925. At the end of 5 years, John’s SEPP plan is done & his IRA will have probably grown into the $1.1mm range.
(2) John can split his IRA into two IRAs A&B with $280,000 in IRA A and $720,000 in IRA B. He sends IRA A to his insurance company of choice and purchases a “term certain immediate annuity” for 5 years which contractually guarantees to pay $60,075 per year for 5 and only 5 years irrespective of whether John is breathing or not. Because John is an astute investor, he invests the other $720,000 in 100% growth stocks which earn 12% per year; thus 5 years later the $780k grows to $1,270mm. In this case, John simply used an annuity product to fund the cash flow required under 72(t) for a 5 year period. Both IRAs A&B are still part of the SEPP plan and can not be used for other purposes; such as starting another, second SEPP plan. Although John used an annuity in this example, it could have just as easily been some other amortizing product, such as: a UIT in mortgages or any other debt product that would fully amortize itself over a 5 year period.
Notice that in both examples (1) and (2) above, John gets $60,075 per year; it is simply a matter of mixing and matching investment devices to suit his needs and desires. Lastly, the SEPP plan is qualified under 72(t) even though an annuity was used as an investment choice for part of the IRA.
(3) John wants more than $60,075 per year and calls his life insurance agent. His agent says that at his age (55) for $1,000,000 he can receive $75,000 per year for life with no certainty; e.g. when he dies the cash distributions stop. Naturally, his life insurance agent says: “Send me the money.”. This is a “life annuity without certainty” and is not the same product as used in (2) above. In this case, the life annuity is qualified under IRC 72(q); not IRC 72(t); therefore the limitations of Rev. Rule 2002-62 do not apply. The good news is that John gets $15k more per year; the bad news is that when John dies, next year or in twenty years, the distributions stop and the IRA is gone.
One might ask how is possible to get more from a life annuity using 72(q) than from a SEPP plan amortizing the same principal amount under 72(t)? The answer lies in the use of interest rates. Anytime the long-term AFR and mid-term AFR are tracking closely; the divergence of distributions under (1)/(2) versus (3) above will be very minor; e.g. the rate that you can use and the rate that the life insurance company chooses to use will naturally be close thus resulting in very similar distribution amounts. Whenever the mid-term AFR diverges from the long-term AFR, almost always (but not 100% of the time) the mid-term rate diverges downward in comparision to the long-term AFR. The insurance companies will continue to use a long-term AFR like interest rate assumption in their pricing of annuity products to the public; a number not unlike 6.5% to 7%. Conversely, we are limited to an interest rate around 4.25%; a full 200 or more basis points lower. Naturally then, the amortization and annuitization formulas under 72(t) will yield correspondingly lower annual distribution amounts. Sound unfair? Well it probably is; however, that’s the law at the moment.
TheBadger
wjstecker@wispertel.net2003-12-23 16:14, By: TheBadger, IP: [38.116.134.130]

L2: Use of Annuities — IRC 72(q) versus Excellent! Got it!
Thank ya, thank ya very much :)2003-12-23 16:37, By: Chris, IP: [24.11.77.192]

L2: Use of Annuities — IRC 72(q) versus What a marvelous clarification!
Thanks TheBadger!
gus2003-12-24 06:42, By: gus, IP: [206.149.200.104]

L2: Use of Annuities — IRC 72(q) versus UNder your item #3 you state the explanation for a life annuity with no period certain. If the annuity has a period certain payout how does this change or modify your response? How about if the period certain is longer or shorter than the life expectancy?2003-12-24 21:02, By: john, IP: [63.195.119.175]

L2: Use of Annuities — IRC 72(q) versus Hello John:
Your asked:
Under your item #3 you state the explanation for a life annuity with no period certain. If the annuity has a period certain payout how does this change or modify your response? How about if the period certain is longer or shorter than the life expectancy?
The key difference between the annuity used in (2) versus (3) is that in (2) the annuity is “term certain”; in my example 5 years and only 5 years; whereas in (3) the annuity is a “life annuity” at least according to whatever the insurance company determines is a lifetime. It is this feature that qualifies the annuity under IRC 72(q). Now, as we all know, life annuities can also have “certainty” periods attached to them. I believe that 5 & 10 year certainties within a life annujity are fine; however, I will confess than I am not a 72(q) expert. Gordon mau have a more complete answer here.
TheBadger
wjstecker@wispertel.net

2003-12-25 09:46, By: TheBadger, IP: [38.116.134.130]

L2: Use of Annuities — IRC 72(q) versus Question: How about if the period certain is longer or shorter than the life expectancy?
No problem if the period certain is less than or equal to the owner’s life expectancy just like the minimum distribution rules.

With that said, let me also say that I’m not a big believer in any annuity with a life contingency purchased much before the age of 75. If someone came to me to use ANY life annuity for a 72(t) or 72(q) distribution, I would do my best to talk them out of it just doesn’t make any sense to me to give away total control of funds for the promise of a life time payment.2003-12-25 11:45, By: Gfw, IP: [172.16.1.70]