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Tuesday, August 6, 2013

Fixed amortization option for IRA distribution versus required minimum distributions

HP-12C calculator and manual next to HP-41 scientific handheld calculator

PHOTO: A standard gold Cross pen sitting on top of the cover of the manual for the HP-12c financial handheld calculator that was manufactured circa 1982 and that I recently used to calculate the fixed amortization of my IRA. It is shown next to the left of a slightly older HP-41C scientific handheld calculator that was so advanced that it could be interfaced to the internet that is still used today. Both calculators were more advanced versions of the first Hewlett-Packard HP-35 handheld calculator introduced in 1972 that was literally lusted after by scientists and engineers despite its price tag of nearly $400 or $1600 in today's inflation adjusted dollars. Both the HP-12C and HP-41C calculators featured a then fairly new liquid crystal LCD display technology and low power CMOS integrated circuits that extended battery life several order of magnitude longer than the original PMOS or NMOS logic circuits and bright red LED light emitting diode displays used in previous calculators. The original HP-35 was developed in the HP Palo Alto advanced research laboratory on the Stanford University campus and it was first manufactured in the HP Cupertino, California facility until a new research & development lab and manufacturing plant could be built in Corvallis, Oregon, where the production of calculators was started in 1976. Calculator production was later moved elsewhere in the world to make space for the rapidly growing HP inkjet printer business that was started originally to provide battery powered printers for HP calculator, but was soon adapted to be used by the then new personal computers, including ones made by HP. (See previous posts History of HP inkjet printers in American Heritage Invention & Technology (1/19/12)), HP-35 scientific calculator anniversary (10/10/07) and HP 12c financial calculator history (6/21/06).

I recently needed to decide how I wanted to make the required money withdrawals from my Individual Retirement Account, also known as an IRA distribution, which the U.S. Internal Revenue Service requires be done at least annually by all IRA owners age 70-1/2 or older to avoid tax penalties.

My nearly 30-year-old HP-12c financial calculator proved to be useful for performing the financial analysis of my IRA options, given its built-in functions to calculate things such as amortizations, annuities and bank loans. My confidence that I still understood the complicated financial calculations and mathematics functions used by the HP-12c was corroborated when I was I was able to use the HP-12C to calculate the same answer, within standard round off error , as the Internal Revenue Service had provided in their examples of IRA distributions. With my HP-12c, I was able to compare using the "Fixed Amortization Method" against using the more commonly known and used "Required minimum Distribution" method of IRA distributions.

Similar to most people, all of my IRA assets were never taxed because my employer either directly took the IRA contributions out of my paycheck before it was taxed or my employer made a matching contribution to my IRA directly with pretax dollars. Also, all of the capital gains and earnings in the IRA are tax-deferred until the money is withdrawn or distributed from the IRA.

As a result, every dollar I take out of my IRA will be taxed the same as if it were ordinary income from a paycheck. This is not a problem if the IRA is small, but my IRA has been around since the IRA first became available in the 1980s and it has grown considerably in size to a point where I felt it was wise to figure out a way to withdraw the money that minimized the taxes I owed over time.

My first thought was to take the easy way out and buy an annuity (e.g. Charles Schwab Annuities), but I quickly discovered that it would be actually easier and better to annuitize the IRA following IRS rules without using a middle man to annuitize it. Later I read an article that used the same idea of amortizing an IRA as a loophole: Matthew Lubanko, "Rule allows withdrawals from IRA accounts before age 59 1/2," posted Apr. 3, 2005. I don't need the loophole, but the article did confirm my understanding of IRS rules for IRA distributions. It also suggests that I could have started earlier and lowered my tax bill even more over a longer period of time.

The bottom line that dawned on me that if your purpose is to legally minimize taxes on IRA distributions and maximize the amount that might be left over for a charitable contribution, where the charity is qualified by the IRS to avoid paying any taxes on the IRA, then the best way to accomplish your goals would be to lock in the low interest rates of today and set up a series of equal payments over your lifetime as allowed by the IRS. (See the charitable contribution I plan in my previous post OSU Foundation Magnus Hirschfeld Fund Agreement (1/4/12))

The U.S. Government's Web page "Retirement Plans FAQs regarding Substantially Equal Periodic Payments," Page Last Reviewed or Updated: 05-Mar-2013 gave me the confidence to ask that my IRA distributions be treated for tax purposes under the IRS-approved "fixed amortization method," as allowed by IRS Publication 590, dated Jan. 30, 2013, p. 56. Instead of using the "Required Minimum distribution method" option after age 70-1/2, I worked out an example of choosing IRA distributions to be "part of substantially equal payments" over a life expectancy of 37.8 years, as specified by the referenced "Uniform Lifetime Table" included in the "Rev. Ruling 2002-62" and published in the Internal Revenue Service Bulletin, bulletin No. 2002-4, Oct. 21, 2002, p. 710-712. (Access these documents by going to IRS forms and publications landing page ) Although not required after age 59-1/2 when unlimited IRA distributions are allowed, I calculated my requested monthly IRA distribution to also comply with the IRS rule of using a chosen "interest rate of not more than 120% of the federal mid-term rate," which was 1.47% in July, 2013. Also for my own notes, my choice to use the less common "fixed amortization method" of IRA distribution, instead of the "RMD method," was based on extensive financial planning advice.

I hadn't done many of these complicated amortization calculations in years and it was decades ago, when I was still in graduate school, when I was expected to be able to prove mathematically the formulas that were later used in the HP-12C. Given my experience, I believe that the slight difference between the HP-12C and the IRS calculations are not due to the HP-12C because I know firsthand that it uses 10-digit accurate, base-10 arithmetic instead of the less accurate 32 bit binary-word arithmetic used by most computers and freebie Web site calculators. In the days before calculators, these types of computations were done using either slide rules or big books that contained recomputed mathematical function tables, which often limited the accuracy of computations to a few decimal places. Of course, it is possible the IRS used a computer program that also factors in the odd number of days in the calendar and other factors that can slightly affect amortization calculations. I was able to quickly do a sensitivity analysis and I quickly realize that this type of accuracy is not required by the IRS and it is of academic interest only because the difference in payments is negligible over the years!

Also see "Index of Applicable Federal Rates (AFR) Rulings," accessed July, 27, 2013 and "Index of Applicable Federal Rates (AFR) Rulings," accessed July, 27, 2013 -- Each month, the IRS provides various prescribed rates for federal income tax purposes. These rates, known as Applicable Federal Rates (or AFRs), are regularly published as revenue rulings. The Fed 30 Year bond rate is an alternative rate for some purposes: "Daily Treasury Yield Curve Rates," Friday Jul 26, 2013 30 year 3.5 percent accessed July 27, 2013