Don’t Be Pushed Into IRA Early-Withdrawal Schemes

It’s not a good idea to take money out of your IRA before you turn 59 1/2. It is, after all, money earmarked for retirement.

But besides the consequence of spending money that might one day pay for cruises and Medicare Part B premiums, there’s the harsh reality of Uncle Sam’s view of early distributions: In addition to taxing the withdrawal at ordinary income rates, the IRS imposes an additional 10% penalty on money IRA owners withdraw early.

Uncle Sam does make some exceptions. For instance, the IRS won’t impose the extra 10% tax when early distributions are due to death, disability and medical expenses that exceed 7.5% of income.

In addition, Uncle Sam looks kindly — no penalty — on early distributions used for qualified higher education expenses, first-time home purchases (limited to $10,000 over a lifetime) and health-insurance payments by unemployed individuals.

And Uncle Sam doesn’t impose the additional 10% tax on early IRA distributions when IRA owners withdraw money in what’s called a series of substantially equal periodic payments, or SEPPs. And it’s these SEPPs that are the topic of the day given recent developments. To wit: At least one firm is now advertising how IRA owners can buy real estate by using SEPPs, thus avoiding the hassles of having the IRA own the property.

In addition, federal regulators last month began a “sweep” of broker/dealers that focuses, according to published reports, on clients’ retirement accounts and the use of a section of the tax code allowing them to withdraw money before turning 59 1/2. The Financial Industry Regulatory Authority is focusing on “all seminars and/or other events directed at potential or early retirees, including prospects that are under 59-and-a-half years old.”

The action follows a June agreement in which Citigroup Group Global Markets will pay more than $15 million to FINRA to settle charges related to “misleading documents and inadequate disclosure in retirement seminars.” According to a release, brokers for Citigroup told BellSouth Employees “that they could afford to retire early by relying upon monthly withdrawals from their retirement savings pursuant to the provisions of Internal Revenue Code Section 72(t).”

Using charts, graphs, handouts and other documents at the seminars and meetings, the brokers’ sales presentations led the employees to expect that for 30 years, they could earn about 12% annually on their investments and withdraw about 9% annually, regulators said.

And what happened in reality was this: More than 200 BellSouth employees saw the principal in their accounts decline by a total of about $12.2 million.

FINRA, the largest nongovernmental regulator for all securities firms doing business in the U.S., was created in July through the consolidation of NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange.

Words To The Wise

Given FINRA’s interest in SEPPs, we thought it wise to offer a word to those who fancy using and those who fancy selling people on using SEPPs to withdraw IRA money prior to age 59 1/2. First, experts generally agree that taking money out of IRA early is not an ideal retirement strategy.

“People should understand that IRA and 401(k) accounts provide powerful tax benefits, but only as long as the money remains in those accounts,” Kaye Thomas, author of soon-to-be-published “Go Roth!,” wrote in an email. “The exception for substantially equal periodic payments should be used only when it suits a particular personal need for which there is no satisfactory alternative. Using this rule to tap a retirement account earlier than necessary may avoid the 10% penalty tax, but has other effects that are often even more costly, as the owner will forgo decades of tax benefits on the money that was withdrawn.”

Barry Picker, author of “Barry Picker’s Guide to Retirement Distribution Planning,” said in an email that IRA owners also should consider whether the need for the money in the IRA is ongoing or a one-shot deal.

“Many people who need money for a specific purpose will set up a SEPP and lock themselves into a withdrawal program, rather than paying the 10% penalty,” he said. “But if the need is one shot, paying the penalty and leaving the rest of the money in the IRA actually works out better in the long run. But people hate the idea of paying the “penalty,” so they set up the SEPP. Paying the penalty is not the worst thing.”

Assuming you need or want to use the SEPP, (some taxpayers who retire early do need to use SEPPs to manage their taxable income and tax brackets), it’s worth knowing that there’s a wrong way and right way to go about this.

The IRS did issue some guidelines, officially called Revenue Ruling 2002-62, that were supposed to help IRA owners use SEPPs the right way. But one of the world’s foremost authorities on the subject, Robert Keebler of Virchow, Krause & Co. in Green Bay, Wis., refers to this guidance as a Trojan horse.

“It looked like good news, but it was really bad news,” he said. “It set up a series of traps.”

Payment Methods

What are those traps? First, you have to understand the methods used to calculate the payments and pick the one that’s right for you. According to Keebler, IRA owners can use one of three methods to calculate their periodic payments: required minimum distribution, fixed amortization or fixed annuitization method.

With the RMD method, the payment is recalculated each year and thus could vary from year to year. The upside to this method: There’s little chance the account won’t have money in it over the period the payments are supposed to be made.

There’s little difference between the other two methods; they both provide fixed payments. But some experts believe it’s easier to calculate payments under the amortization method. The big drawback is that it’s possible, due to market volatility and how the money is invested, the IRA could have little or no money in it before the payment period ends.

Of note, one can switch once and only once from the fixed method to the RMD method but not from the RMD to the fixed method.

Material Modifications

And therein lies another trap. According to Picker, the payments must continue for the greater of five years, counting from the date of the first distribution, or until age 59 1/2.

But if payments are “materially modified” prior to that point, Keebler notes that the 10% additional tax will be imposed on all pre-59 1/2 withdrawals. In addition to the 10% additional tax, an additional amount is added to reflect the interest on the penalty from the original year of withdrawal.

According to experts, the “material modification” part about SEPPs is the one that trips up a lot of people. “Once the SEPP is set up, it must be followed religiously, with no deviation,” Picker said. “That includes no transfers into or out of the IRA that the SEPP is coming from.”

According to Keebler, one way to avoid the material modification trap is to establish one IRA solely for SEPPs and one for future distributions and other contingencies.

Calculate The Right Rate

In calculating the SEPP, IRA owners have to determine which interest rate (120% of the midterm Applicable Federal Rate or AFR) and which life expectancy table (single, joint, or uniform life) to use. (One gets automatically admitted into Mensa if they can figure out which rate to use for SEPPs by the way. For those that need help, a visit online to 72t might be in order.)

So much can go wrong with setting up SEPPs that it’s no wonder that federal regulators are investigating 72(t) scams. So what’s the best advice?

Any SEPP “needs to be properly set up and properly adhered to,” Picker said. “Failure at either point renders the plan improper, which means all distributions up to age 59 1/2 will be subject to the 10% penalty, plus interest.”

The Philadelphia Stock Exchange has hired Greenhill & Co. (GHL) to help it find a buyer or arrange an initial public offering, formalizing a months-long effort by the exchange’s owners to sell their stakes.

The oldest U.S. securities exchange, founded in 1790, is accelerating its sales efforts at a time when its fortunes are on the rise. It closed its stock-trading floor last year, but has built a thriving business in stock options and now ranks as the third-largest options exchange behind the Chicago Board Options Exchange and the all-electronic International Securities Exchange (ISE).

Options trading volume is at record levels, as investors seek to hedge or exploit market volatility, and rival exchanges such as the Nasdaq Stock Market (NDAQ) and NYSE Euronext (NYX) are seen as likely buyers as they seek to expand their franchises beyond stock trading. Neither exchange would comment.

“We’ve hired Greenhill to assess our strategic options, and the board will ultimately determine what we are going to pursue,” said Philadelphia Stock Exchange Chairman and Chief Executive Meyer Frucher.

He wouldn’t comment on the likelihood of a deal, but a person close to the process said he anticipates that a sale at a minimum of about $400 million could occur within the next few months. An initial public offering would most likely have to be pushed into late 2008, another person said.

Frucher held talks with potential buyers prior to hiring Greenhill earlier this month, but the exchange’s asking price has risen in the interim along with its market share. Philadelphia’s share of exchange-traded options volume jumped to 15.6% in July from 13.5% in all of 2006 and 11% in 2005, according to the Options Clearing Corp. The exchange also still sees a small amount of electronic stock trading.

Philadelphia’s negotiating stance also may have been whetted by the ISE’s agreement earlier this year to sell itself to Deutsche Borse’s Eurex unit for $2.8 billion at a healthy 44 times ISE’s earnings.

The Philadelphia exchange had a pretax gain of $8.93 million in 2006, reversing a $14.9 million loss the previous year. It lost $424 million last year on an after-tax basis.

Philadelphia is likely to exploit the need of exchanges focused on single markets such as equities or futures to expand their product bases as they compete with off-exchange trading platforms.

Prospective buyers such as Nasdaq and NYSE Euronext could easily digest the regional exchange despite other deals they have recently completed or are pursuing, analysts said. The heads of both exchanges have targeted options trading as a likely area of expansion.

“They are capable of absorbing Philadelphia, and they will all look at it,” said Richard Repetto, an analyst at Sandler O’Neill & Partners.

NYSE, which owns the New York Stock Exchange, bought Euronext NV last April. Nasdaq built a 30% stake in the London Stock Exchange (LSE.LN) in a failed effort to buy the LSE and has an agreement to buy Nordic exchange operator OMX AB (OMX.SK) for about $3.7 billion. Greenhill represented Nasdaq in its LSE bid.

Other potential buyers could include the New York Mercantile Exchange (NMX), the International Commodities Exchange and the Chicago Board Options Exchange, though CBOE is embroiled in a trading rights battle with members of the Chicago Board of Trade that could make it difficult to participate in an auction.

Philadelphia’s sales negotiations earlier this year stalled, when a former seatholder filed a lawsuit accusing the exchange of diluting former members’ ownership interests when it sold a majority stake to six Wall Street firms in 2005 and 2006. The exchange reached a preliminary settlement of the lawsuit in late June, though terms weren’t disclosed.

Units of Citigroup Inc. (C), Credit Suisse Group (CS), Merrill Lynch & Co. (MER), Morgan Stanley (MS), UBS AG (UBS) and Citadel, a Chicago-based hedge fund, owned just under 90% of the Philadelphia exchange, with the biggest stakes controlled by Citadel, Merrill and Morgan Stanley. Frucher and other exchange executives cumulatively own a little more than 5% of the exchange’s equity. Those stakes will change once the settlement is final.

By Jed Horowitz, Dow Jones Newswires; 201-938-4047; jed.horowitz@dowjones.com

As expected the Fed held the fed fund target rate at 5.25%

The statement said (for comparison the prior statement is immediately below today’s)

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information

Economic growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector. The economy seems likely to continue to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.