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Wednesday, October 8, 2014

IRS IRA distribution substantially equal payments method

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 a manual for the Hewlett-Packard Model HP-12C financial handheld calculator manufactured circa 1982, which I used to calculate the fixed amortization amount for my IRA required by the IRS starting at Age 70-1/2. It is shown to the left of a slightly older HP-41C scientific handheld calculator that was so advanced it could be interfaced to the internet cloud still in use today. See previous posts Fixed amortization option for IRA distribution versus required minimum distributions (8/6/13) and HP 12c financial calculator history (6/21/06)

I am at the age when the IRS will soon be requiring me to withdraw money from my Individual Retirement Account and pay ordinary income taxes on it. Most people use the required minimum distribution method starting at age 70-1/2 based on the idea that keeping the money growing tax-free in an IRA as long as possible will minimize taxes paid.

I have also considered using the IRS-approved IRA distribution method of taking "substantially equal payments," in lieu of taking the "required minimum distributions" starting at Age 70-1/2.

Although it no longer applies to me, I had previously considered using IRS rules that permit a penalty-free early IRA withdrawal, by using the same "substantially equal payments" method I am considering using today, however, this has some other restrictions that will not apply to me because I will be starting withdraws from my IRA after age 59-1/2.

IRS guidelines describe a "fixed amortization method" for calculating the "substantially equal payments" amount by using the IRS "life expectancy table" that states a 59 year old should live 37.8 years longer and a 60 year old will live 36. 8 years longer. The law requires the calculation be reasonable and one IRS Bulletin says the interest rate used must be less than 120% of the "Federal Mid-term Rate" for either of the two months before the early distribution begins, if the distribution is started early before age 59-1/2.

Below is an example calculation using an HP 12-C financial calculator to figure out an IRA distribution amount's equivalent interest rate:

  • Given an IRA balance on Apr. 30, 2014 of $452,437.25 before the IRA distributions of $14,076 per year were started at age 59-1/2 with a 37 years life expectancy:(be sure to use yellow button to clear financial registers before entering any numbers listed below)
  • n = 37 years number of annual payments based on life expectancy at age 59-1/2
  • PV = $452,437.25 present value of IRA Apr. 30, 2014
  • PMT = -$14,076 annual distribution from IRA = $1,173 per month x 12 months per year
  • FV = $0 future value of IRA after 37 years assuming complete payout
  • Press the "i" button without entering any amount and the HP-12C calculates:
  • i= 0.76% amortization interest rate

For reference, assuming a 0% rate at age 59-1/2, and a May 30, 2014 IRA balance of ($461,484.05 / 37 years life expectancy) / 12 payments per year = $1,039.38 per month versus the above chosen distribution = $1,173 per month (or $14,076 per year).

The IRS life expectancy table ranges from 27.4 years at age 70 to 1.9 years at age 115 and over, which will change the IRA distribution values calculated above for every year it is done, unless the substantially equal payments method is used.

Some ley links to IRS instructions and documents for calculating IRA distributions: