Would breaking a 72(t) of a Roth be free of the 10% penalty if there is 5-year

[swampwiz]

Would breaking a 72(t) of a Roth be free of the 10% penalty if there is 5-year conversion basis available?  (The forum needs to allow longer titles!)

While admiring my wonderful spreadsheet to carefully track my laddered Roth conversions over the years, a thought popped into my mind: if I am doing my Roth distributions as part of a 72(t) plan - this will be something that I will have my custodian set up and therefore be responsible for - and I decide to prematurely end it, if my distributions have not exceeded the 5-year Roth conversion basis, would I have any increase in tax liability?  I ask this because it sure seems that if I start doing such a 72(t) plan, I necessarily have to account for those distributions against conversion basis, and because it seems that the extra tax liability incurred by breaking the plan is in essence like a recharacterization of those distributions.  This would allow for a pain-free ceasing of the plan if I am still in the positive for 5-year conversion basis - in essence allowing me to choose to have a lower time commitment that the 5 years (i.e., any time while still distributing 5-year conversion basis would be free).

[secondcor521]

Perhaps I don't understand.  Why would you do a 72(t) on a Roth IRA?  If you withdraw money from a Roth IRA under a 72(t) plan, you would owe ordinary income taxes on the withdrawal amount from the Roth IRA.  Since there are usually ways to withdraw from a Roth IRA tax free (including withdrawal of contributions and conversions that have seasoned for five tax years as part of a Roth pipeline), 72(t) is usually not recommended from a Roth.

Also, you understand that the commitment to a 72(t) is not 5 years, it is 5 years or until age 59 1/2, whichever is longer.  How old would you be when you want to start withdrawing?

[swampwiz]

Perhaps I don't understand.  Why would you do a 72(t) on a Roth IRA?  If you withdraw money from a Roth IRA under a 72(t) plan, you would owe ordinary income taxes on the withdrawal amount from the Roth IRA.  Since there are usually ways to withdraw from a Roth IRA tax free (including withdrawal of contributions and conversions that have seasoned for five tax years as part of a Roth pipeline), 72(t) is usually not recommended from a Roth.

Also, you understand that the commitment to a 72(t) is not 5 years, it is 5 years or until age 59 1/2, whichever is longer.  How old would you be when you want to start withdrawing?

I would be needing to take out more than the 5-year Roth conversion basis, and before age 59-1/2, hence the idea would be to avoid the 10% penalty (as I would have $0 income, and thus a $12K in the 0% tax rate bracket, the taxableness of the early Roth distribution would not matter).  I probably could handle the situation with non-IRA funds and 5-year Roth conversion basis, but if my hunch about this topic is correct, this would allow me to essentially have a free way to break the 72(t) so long as the amounts I will have had distributed would have been as 5-year conversion basis.

As for the taxableness of a 72(t) distribution, it is treated just like an regular IRA distribution done after age 59-1/2, so a Roth distribution is non-taxable.

[secondcor521]

I am not an expert on 72(t), but I did read a lot about them perhaps 10 years ago when I was considering doing one myself.

I think your hunch is incorrect and I think your understanding of the taxability of a 72(t) from a Roth is mistaken.

I don't think there is any way to retroactively convert 72(t) withdrawals to Roth contribution/conversion withdrawals.

I also don't think there is any way to avoid the 72(t) penalties for breaking a SEPP in a typical situation, although I have heard since I did my research that the penalties have been lessened in situations where you've completely depleted the IRA and perhaps some others.

People discover tax loopholes on occasion, and most of the ones that work are well known.  More frequently - and I believe this is the case with your idea - people think they have discovered tax loopholes only to find out that the IRS and Congress have written the law in such a way that the loophole simply doesn't work.

I'd suggest sitting down with a tax program or a CPA or some combination of the two and discuss your plans and make sure they will work before you try them.  You might also try 72t.net, which I think is a knowledgeable site about the subject (maybe more so than an average tax preparer).

Good luck!

[swampwiz]

I think your hunch is incorrect and I think your understanding of the taxability of a 72(t) from a Roth is mistaken.

I don't think there is any way to retroactively convert 72(t) withdrawals to Roth contribution/conversion withdrawals.

I'd suggest sitting down with a tax program or a CPA or some combination of the two and discuss your plans and make sure they will work before you try them.  You might also try 72t.net, which I think is a knowledgeable site about the subject (maybe more so than an average tax preparer).

Good luck!

If I paid for all this advice, I suspect that I'd be using whatever tax gain I would be receiving on the advice.

I think you're missing the point about the retroactive conversion.  Breaking a 72(t) is akin to doing a Roth conversion recharacterization in that the filer simply amends his returns and pays whatever tax and early-distribution penalty (and the interest on that penalty, which is not really a loss) that would have been due had he just done the actions outside of the 72(t).  The idea here is that going back and having that 5-year conversion basis distributed outside of the 72(t) would not generate taxable income nor the early-distribution penalty.  Why would the Roth be "converted" back to a TIRA?

Obviously, Moustaschers seem to not be experts on the 72(t), and the IRS doesn't seem to help much by giving proper direction (other than to have a specific question asked in a "private letter ruling" at the $100 price of whatever), with lots of FUD around.  I will post my question at a forum that refers to itself as the experts on 72(t): https://72t.net

[secondcor521]

I have treaded lightly so far because I don't 100% understand exactly what your plan is and I'm about 99% certain that you don't actually correctly understand what the tax laws and rules are about both 72(t) and Roth conversion pipelines.  I suspect that trying to clarify either of these topics might be a lengthy and difficult process for which I am not sure I have the appetite.

But I'd like to try on a limited basis to keep going on this topic because I do know some things about this subject.  (Or at least I'm fairly certain that I do.  But to you, of course, I am just SGOTI.)

So first of all, what it sounds like your potential plan is to me:  Start a 72(t) series of substantially equal periodic payments from your Roth IRA by notifying your custodian.  After a few years, there may be some reason you wish to stop the 72(t) payments.  You do so by notifying your custodian.  You then go amend your tax returns for those years, wishing to restate those payments as Roth withdrawals against your "5 year conversion basis".  By this latter term I think you must mean the sum of your contributions plus any conversions that are older than 5 tax years at the time the withdrawals were originally made.

So let me state and restate some of my concerns that I think you might be wise to try to clarify:

1.  First, your original post seems to suggest that you think that the minimum time requirement for a 72(t) SEPP plan is 5 years when you write "lower time commitment that the 5 years".  The minimum time requirement for a 72(t) SEPP plan is 5 years or until age 59.5, whichever is *longer*.  So if you start this plan at age 45, the minimum time would be 14 or 15 years, not 5.  This is not directly applicable to your plan, since you think you have a way to break the plan early.  But if you are wrong, it does point out that the downside risk is potentially longer/larger than you think it is, so I wanted to restate it.

2.  As I think you know, you can only amend tax returns going back 3 tax years.  So one problem with your plan is if you start a 72(t) plan and decide to end it in year 4, you would not be able to amend that first tax year, which would logically therefore still include a 72(t) withdrawal.  The IRS could then see that you had broken a 72(t) in year 2 and would assess taxes and penalties accordingly.

3.  You believe that 72(t) withdrawals from a Roth are exempt from ordinary income taxes.  They are not and I believe you are flat-out wrong on this, but feel free to search the IRS site and/or find a reputable expert to ask.  This is a little understood point about 72(t), but it is true and is one of the main reasons why SEPPs are practically never done on Roth IRAs.

As one quick citation, please see the first page of this Vanguard document (https://personal.vanguard.com/pdf/s164.pdf) which states "Ordinary income tax Yes.**"  This is also a short and reasonably understandable primer on SEPPs from a reputable source.

So your plan doesn't make sense to me from a practical point of view:  You'd be paying ordinary income tax on your withdrawals from your Roth under a plan which avoids the 10% penalty yet requires you to continue making those withdrawals for possibly longer than you want in order to preserve the option to retroactively amend your taxes (i.e., do extra work) to a situation where, had you just done regular withdrawals in the first place (as part of a Roth pipeline), you would have owed neither ordinary income tax nor the 10% penalty and would not have been obligated to continue the withdrawals in the first place.

4.  Setting all that aside, part of your plan seems to hinge on amending your taxes to retroactively change your withdrawal from a 72(t) to a regular withdrawal.  I see a problem here.  When you make the withdrawal, your custodian has to report a code to the IRS on the 1099-R so that the IRS knows what the proper taxation of that withdrawal should be.  Presumably under your plan, when you make your withdrawals initially, your custodian will report them to the IRS with a SEPP withdrawal code.  Later if you chose to change  your plans and amend your taxes, you're wanting to just tell the IRS that the withdrawal was not part of an SEPP.  But the IRS has a 1099-R that says that it was.  Either you will have to have a discrepancy between your amended tax return (which says that the payment was not part of a SEPP) and the original 1099-R (which says that it was part of an SEPP), OR you will have to get your IRA custodian to issue a new 1099-R to the IRS with a different code.  In the former case, I think this subjects you to audit risk and retroactive penalties by the IRS.  In the latter case, I think your IRA custodian will say that they can't and won't do that.  How do you plan to address this difficulty?

...

To answer your question here:  "Why would the Roth be "converted" back to a TIRA?" I assume you are referring to what I wrote:  "I don't think there is any way to retroactively convert 72(t) withdrawals to Roth contribution/conversion withdrawals."  My sentence is (1) a more compact statement of item 4 above, and (2) was referring to the fact that you were wanting to conditionally change your withdrawals to being from "5 year conversion basis", which to me can only mean - based on how the IRS treats the ordering of Roth IRA withdrawals - from your Roth IRA contributions then from any conversions you have made to your Roth IRA from your traditional IRA.

5.  You seem to want flexibility.  I think you understand this, but SEPPs, generally once you choose a plan, the amounts are fixed down to the penny.  See "An important note" towards the beginning of this Forbes article:  https://www.forbes.com/sites/advisor/2012/02/13/the-72t-early-distribution-from-your-ira/#1d8173aa2068

It sounds to me like you've drawn some conclusions based on incorrect information you've heard along with your common sense and logic.  Unfortunately, common sense, logic, and how we think things ought to work don't always apply to taxes.

Good luck!

[swampwiz]

So first of all, what it sounds like your potential plan is to me:  Start a 72(t) series of substantially equal periodic payments from your Roth IRA by notifying your custodian.  After a few years, there may be some reason you wish to stop the 72(t) payments.  You do so by notifying your custodian.  You then go amend your tax returns for those years, wishing to restate those payments as Roth withdrawals against your "5 year conversion basis".  By this latter term I think you must mean the sum of your contributions plus any conversions that are older than 5 tax years at the time the withdrawals were originally made.

So let me state and restate some of my concerns that I think you might be wise to try to clarify:

1.  First, your original post seems to suggest that you think that the minimum time requirement for a 72(t) SEPP plan is 5 years when you write "lower time commitment that the 5 years".  The minimum time requirement for a 72(t) SEPP plan is 5 years or until age 59.5, whichever is *longer*.  So if you start this plan at age 45, the minimum time would be 14 or 15 years, not 5.  This is not directly applicable to your plan, since you think you have a way to break the plan early.  But if you are wrong, it does point out that the downside risk is potentially longer/larger than you think it is, so I wanted to restate it.

Yes, I just used the 5-year designation to mean "5-year or age 59-1/2, whichever is later".

2.  As I think you know, you can only amend tax returns going back 3 tax years.  So one problem with your plan is if you start a 72(t) plan and decide to end it in year 4, you would not be able to amend that first tax year, which would logically therefore still include a 72(t) withdrawal.  The IRS could then see that you had broken a 72(t) in year 2 and would assess taxes and penalties accordingly.

Not quite.  Even though I would not be able to do an amended return after 3 years, the IRS would in essence be doing the amended return, and I would certainly have the legal right for them to do it properly as if I did the return myself.

3.  You believe that 72(t) withdrawals from a Roth are exempt from ordinary income taxes.  They are not and I believe you are flat-out wrong on this, but feel free to search the IRS site and/or find a reputable expert to ask.  This is a little understood point about 72(t), but it is true and is one of the main reasons why SEPPs are practically never done on Roth IRAs.

As one quick citation, please see the first page of this Vanguard document (https://personal.vanguard.com/pdf/s164.pdf) which states "Ordinary income tax Yes.**"  This is also a short and reasonably understandable primer on SEPPs from a reputable source.

Vanguard document has the footnote:

**Refer to IRS Publication 590, Individual Retirement Arrangements (IRAs), or consult your tax advisor for more information on
the taxation of IRA distributions

So the question is where is the documentation from the IRS?  The whole idea of a SEPP is to avoid the 10% penalty associated with early distribution, so why would there be tax levied?

So your plan doesn't make sense to me from a practical point of view:  You'd be paying ordinary income tax on your withdrawals from your Roth under a plan which avoids the 10% penalty yet requires you to continue making those withdrawals for possibly longer than you want in order to preserve the option to retroactively amend your taxes (i.e., do extra work) to a situation where, had you just done regular withdrawals in the first place (as part of a Roth pipeline), you would have owed neither ordinary income tax nor the 10% penalty and would not have been obligated to continue the withdrawals in the first place.

The big IF is the taxability of the Roth, so until there is some documentation from the IRS, or the Internal Revenue Code, that settles this definitely, it's an open question.  Of course, if the Roth distributions are treated as taxable, just that alone would make simply taking the 10% penalty on whatever amount I would need to take out before 59-1/2 - that is over and above what I have in the 5-year conversion basis pipeline, but less than the total conversion basis - to meet my financial goals the better deal.  Perhaps the Roth SEPP is not taxed for the 5-year or total conversion basis?  WHERE IS THE DOCUMENTATION?

4.  Setting all that aside, part of your plan seems to hinge on amending your taxes to retroactively change your withdrawal from a 72(t) to a regular withdrawal.  I see a problem here.  When you make the withdrawal, your custodian has to report a code to the IRS on the 1099-R so that the IRS knows what the proper taxation of that withdrawal should be.  Presumably under your plan, when you make your withdrawals initially, your custodian will report them to the IRS with a SEPP withdrawal code.  Later if you chose to change  your plans and amend your taxes, you're wanting to just tell the IRS that the withdrawal was not part of an SEPP.  But the IRS has a 1099-R that says that it was.  Either you will have to have a discrepancy between your amended tax return (which says that the payment was not part of a SEPP) and the original 1099-R (which says that it was part of an SEPP), OR you will have to get your IRA custodian to issue a new 1099-R to the IRS with a different code.  In the former case, I think this subjects you to audit risk and retroactive penalties by the IRS.  In the latter case, I think your IRA custodian will say that they can't and won't do that.  How do you plan to address this difficulty?

I would presume that what would be done is to include a private letter that states that the SEPP on the Roth IRA that became active on ... has been deactivated on ..., and that as such a redo of the tax forms would be as per the redone 8606 form for the years during which the SEPP had been active - which would not have any effect on the 8606 form because the taxable or penaltiable amount would still be $0.  It should be noted that the only way that a code for a SEPP gets entered is if the 5-year seasoning runs out, in which case the 5329 form is filled out, which is where the 10% penalty gets assessed OR is not accessed because "an exception applies".  The IRS would only be able to levy the 10% penalty by recoding the "an exception applies" to "no exception applies", but if there is nothing on that form, there is nothing to levy the penalty against!

The IRS treats a deactivated SEPP in the same way that it treats a Roth recharacterization in that everything goes back as if the corresponding Roth conversion had not happened (aside from interest, but not a penalty, on the extra taxes).  Here, the "had not happened" would be the SEPP, so the Roth distributions would be treated as if they had never happened, and instead were regular Roth distributions, which would under this whole hypothetical scenario be from the 5-year conversion basis corresponding to the year of the distribution.  Of course, this would probably be audited, but I would be able to prove the Roth conversions for every year thereby backing up my claim of the 5-year conversion basis taxable-income-free and penalty-free status.  The custodian would not have to do anything concerning past year 1099 forms, and simply issue different 1099 forms for the year in which the SEPP was deactiviated for the amounts that were done before and after the deactivation, and perhaps some official memo of action to the IRS about the SEPP being broken.

To answer your question here:  "Why would the Roth be "converted" back to a TIRA?" I assume you are referring to what I wrote:  "I don't think there is any way to retroactively convert 72(t) withdrawals to Roth contribution/conversion withdrawals."  My sentence is (1) a more compact statement of item 4 above, and (2) was referring to the fact that you were wanting to conditionally change your withdrawals to being from "5 year conversion basis", which to me can only mean - based on how the IRS treats the ordering of Roth IRA withdrawals - from your Roth IRA contributions then from any conversions you have made to your Roth IRA from your traditional IRA.

The way I read the instructions for the 8606 form, there is nothing there that allows me to do anything but deduct the distributions, SEPP or no SEPP, from the conversion basis (the form has no mention of 5-year basis; I guess the IRS doesn't want this loophole advertised), and I like I had said, I would not be using the 5329 form.

5.  You seem to want flexibility.  I think you understand this, but SEPPs, generally once you choose a plan, the amounts are fixed down to the penny.

The flexibility I seek is in case I come into a situation in which I don't need to take out Roth distributions for the remainder of the required time, I want to be able to just end it.  The whole idea is based on the premise that the only thing that happens with a broken SEPP is that all the distributions made up until that time are treated as if they had not been part of the SEPP, which as I had mentioned many times, is the same idea as the Roth recharacterization.  If I have no distributions during that time that would have as well not generated a tax liability, then I would not have any tax liability for going back and treating them that way.

See "An important note" towards the beginning of this Forbes article:  https://www.forbes.com/sites/advisor/2012/02/13/the-72t-early-distribution-from-your-ira/#1d8173aa2068

It sounds to me like you've drawn some conclusions based on incorrect information you've heard along with your common sense and logic.  Unfortunately, common sense, logic, and how we think things ought to work don't always apply to taxes.

Good luck!

It seems that the only disagreements we have is whether Roth distributions in a SEPP are treated as if they were a TIRA, and about the allocation of seasoning times of the conversion basis.  As for the latter, the 8606 form documentation makes absolutely no mention of how a SEPP changes the entries on that form, so I think I have won that argument.  So all we are left with is the question of the taxable income effect.  The IRA would be registered with the custodian as being Roth, so the code would either be 2 (early distribution, exception applies) or J (no known exception), with the latter being addressed via a private letter. in either case, the exception applies, so it is not considered *early*, which is the whole point of the SEPP.

[secondcor521]

That's a lot to digest.  A few selected replies:

0:  "IRS would in essence be doing the amended return"
0:  I have no idea what this means.  The IRS doesn't do amended returns for people as far as I know.

Q1:  "So the question is where is the documentation from the IRS?"
A1:  Publication 590 can be found on the IRS website at http://www.irs.gov.  The part relating to withdrawals is now Pub 590-B here:  https://www.irs.gov/pub/irs-pdf/p590b.pdf.  The actual tax code about 72(t) can be found in Title 26 of US Code, a copy of which you can read here:  https://www.law.cornell.edu/uscode/text/26/72.  The part about penalties for discontinuing an SEPP is in 72(t)(4).

Q2:  "The whole idea of a SEPP is to avoid the 10% penalty associated with early distribution, so why would there be tax levied?"
A2:  Here is one place where you mistake logic and your opinion for tax law.  I think part if it is that SEPPs were in the tax law before Roth IRAs were created.  Have you asked over at 72t.net or anywhere else if your assumption that SEPPs from Roths are non-taxable is accurate?

3:  "until there is some documentation from the IRS, or the Internal Revenue Code, that settles this definitely"
3:  See Q1/A1 above.

Q4:  "WHERE IS THE DOCUMENTATION?"
A4:  See Q1/A1 above.

5:  "include a private letter that states"
5:  This is not the usual meaning or use of a private letter, but whatever.

6:  "The IRS treats a deactivated SEPP in the same way that it treats a Roth recharacterization"
6:  No they don't.  They're two different sections of the tax law and treated differently.

7:  "The custodian would not have to do anything concerning past year 1099 forms, and simply issue different 1099 forms for the year in which the SEPP was deactiviated for the amounts that were done before and after the deactivation, and perhaps some official memo of action to the IRS about the SEPP being broken."
7:  Yeah, good luck with that.  Have you called your IRA custodian and ensured that they're willing to do this for you?

8:  "no mention of 5-year basis"
8:  I think it's in the instructions for Form 8606 Part II, but it's been a while since I looked.

9:  "which as I had mentioned many times, is the same idea as the Roth recharacterization"
9:  You're still incorrect, no matter how many times you say it.  See 6 above.

10:  "SEPP are treated as if they were a TIRA"
10:  I believe I said it would be treated as taxable income.  Two different statements.

Two parting links that you may find helpful from 72t.net:

https://72t.net/72t/FAQ#Faq105 ("Are there any IRS filing requirements?")
https://72t.net/72t/FAQ#Faq201 ("How do I report a broken SEPP?")

I will close by saying that I'm done with this thread.  I've tried to be helpful and point you to pitfalls in your plan, areas where I think you've misunderstood how the tax law works in this area, and provided resources and links for you to further research.  So far you seem to be convinced you are correct - mostly through repetition and without research or citation.   I'm fairly certain that if I continued engaging with you that there would be little to no chance of you considering changing your mind.  Fill out your tax forms however you want to, and I wish you the best of luck in your endeavors.

[secondcor521]

I forgot to add that I did make a mistake on this thread where I said the code for the SEPP was put on the 1099-R.  As one of the links from 72t.net implies, the code I was referring to is actually in the instructions for Form 5239 line 2.

Form 5329 can be found here:

https://www.irs.gov/pub/irs-pdf/i5329.pdf

The codes I'm referring to are on page 4 of the above PDF, column 1.

[swampwiz]

The code says:

(t)(4)(ii)(II)

"Change in substantially equal payments

In general If— the series of payments under such paragraph are subsequently modified (other than by reason of death or disability or a distribution to which paragraph (10) applies)—the taxpayer’s tax for the 1st taxable year in which such modification occurs shall be increased by an amount, determined under regulations, equal to the tax which (but for paragraph (2)(A)(iv)) would have been imposed, plus interest for the deferral period."

So, the IRS will functionally AMEND the tax forms for those years having those distributions be as NOT in a SEPP.

Also notice that all that 72(t) addresses is the ability to avoid the 10% penalty, so that would seem to indicate that the taxability of income from a SEPP Roth distribution matches that of a Roth as being NOT part of a SEPP.  This means that any Roth conversion basis (of any seasoning length) will remain as untaxed, but that anything past that will be taxed, so in this sense, you are somewhat correct.  Roth distributions lose their Roth-ness once the conversion basis has been exhausted, although for the extent that the taxpayer is in the 0% bracket, it would not be an issue. 

So, the main speculation that I had put forth is correct, since in any case the breakage of the Roth SEPP plan would be done before exhausting of the 5-year conversion basis.  However, another speculation I had - that the Roth SEPP would be treated as if I were 59-1/2 was partly correct (no tax or penalty for total conversion basis) and incorrect (no tax when past total conversion basis).

So it is not a complete win-win, but it is not a lose-lose either.

[grantmeaname]

So, the IRS will functionally AMEND the tax forms for those years having those distributions be as NOT in a SEPP.

That's not what your citation says at all. It says that after you break a series of payments, you need to calculate the understatement of income from all the years at question, roll them forward with interest, and place them on your return as additional tax.

that would seem to indicate

Tax law is hard. Any time you say this phrase there should be alarms and giant red flags in your mind that you need to obtain advice or do more research.

[swampwiz]

So, the IRS will functionally AMEND the tax forms for those years having those distributions be as NOT in a SEPP.

That's not what your citation says at all. It says that after you break a series of payments, you need to calculate the understatement of income from all the years at question, roll them forward with interest, and place them on your return as additional tax.

OK, so the IRS expects the taxpayer to *functionally* amend those earlier tax forms as if the distributions had not been done as per a SEPP.  It won't be form 1040X with updated form 8606, and instead be some other form, but in the end, the taxes will be recalculated as if the SEPP had not been done, with the difference in tax due plus interested (the latter is not really a cost as it is just a finance charge at a fairly low interest rate).  And if the taxpayer fails to do this, the IRS will DO IT FOR HIM and send him a letter saying you owe this.

[grantmeaname]

Why not just skip doing your return at all until the IRS does it for you and sends you a nice letter with your liability?