Annuity Factor Method

For people who need to begin receiving distributions from qualified retirement accounts prior to age 59 ½, the Internal Revenue Service has established sections 72(t) and 72(q) to allow for penalty-free early withdrawals. Investors who take distributions prior to age 59 ½ are advised to bear in mind that while they may be able to take early distributions without paying the 10% excise tax penalty, the distributions may not be free of income tax. As retirement accounts are funded with pre-tax dollars, income tax is paid in the year the money is distributed.

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Factor Method Details

The annuity factor method is the most complicated way of establishing the amount of the payments a person is allowed to receive penalty-free. 72(t) and 72(q) early distributions must be made in a manner that is known as Substantially Equal Periodic Payments (SEPP). The SEPP are based on the life expectancy of the account owner at the time the distributions begin and the total balance of the account or accounts. By following the SEPP payment schedule and proper calculations, the account owner will avoid the 10% early distribution penalty.

There are a number of reasons an investor may need to begin early withdrawals and use the annuity factor method to determine the amount of each distribution. If, for example, the value of his or her retirement account has grown so substantially that he or she will be in a higher tax bracket, as opposed to the oft assumed lower tax bracket once distributions begin after age 59 ½, he or she may want to begin taking smaller payouts earlier. This can often be the case with small business owners and executives who receive shares of company stock or stock options as part of a qualified plan. It can also occur when young workers choose to purchase growth stocks for a large part of their retirement accounts.

How Does the Annuity Factor Method Work

To calculate penalty-free distribution payments using the annuity factor method, the total account value of the qualified account is what is called the “annuity factor”. In financial terms, the annuity factor is defined as the current value of a payout of $1 per year per the number of years of the recipient’s life expectancy, based upon a reasonable mortality table and a reasonable rate of interest at the time the payments begin.

Under current annuity factor method calculations, an account owner can use up to 120% of the mid-term applicable federal rate as the “reasonable” rate of interest. (The mid-term rate is published by the Internal Revenue Service and is based on the debt that has a maturity date of more than three years but not more than nine years.) He or she must use IRS Ruling 2002-62 Appendix B as the actuarial table to determine life expectancy.

The entire calculation is based on the life expectancy of the account owner at the time distributions begin, the present value of $1, the assumed interest rate and the total value of the account. Retirement account owners interested in the annuity factor method can download an annuity factor calculator here (

If using the annuity factor method to calculate the amount of the yearly distribution, the amount distributed is fixed for the first five years. The account owner cannot recalculate the amount of the distributions until five years or until he or she reaches age 59 ½, whichever comes later.

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What are the Benefits of the Annuity Factor Method

One benefit of the annuity factor method is the ability to receive distributions from a qualified retirement plan without having to pay the 10% penalty. Another advantage is that, depending on the size of the account, the payments can be large enough and last long enough to provide enough income until distributions on other qualified accounts are taken after age 59 ½. Finally, if the distributions provide the only income a person receives each year, his or her tax burden may be substantially reduced compared to prior years in which income was earned.

Annuity Factor Method Compared to the Life Expectancy and Amortization Methods

There are two other methods of calculating penalty-free early withdrawals from individual retirement accounts: The life expectancy method and the amortization method.

The Life Expectancy Method

This is the easiest method of early distribution to calculate. The total value of the retirement account is divided by life expectancy. For example, if a 53-year-old single man wants distributions to begin in 2011, he must first calculate the total account value as of December 31, 2010 and his life expectancy according to IRS Publication 590 Appendix C. If the account value were $250,000 and his life expectancy is 31.4 years, the amount he can receive in distributions each year is $7,962.

The following year, the now 54-year-old would again take the account balance on December 31 and divide the amount by 30.5, his new life expectancy. He must do this each for five years in order to receive distributions penalty-free. If he does not, he will subject to the tax retroactively.

The Amortization Method

The amortization method of calculating early withdrawals allows the account holder to amortize the value of his or her individual retirement accounts over his or her life expectancy using the reasonable assumption of the rate of interest that will be earned on the accounts. As previously stated, this can be up to 120% of the mid-term rate.

If the mid-term rate is 4.0%, a “reasonable” rate of 4.8% (4.0% x 120% = 4.8%) can be used. Therefore, a 54-year-old man with an account balance $250,000 and a life expectancy of 31.4 years would be able to withdraw approximately $6,200. The amortization method requires payments be fixed for five years, unlike the life expectancy method.

As with all qualified retirement account distributions, investors are strongly urged to consult with a knowledgeable tax consultant or attorney in order to accurately gauge the impact of withdrawals. Further information about the annuity factor method can also be obtained on the Internal Revenue Service website.

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