Fixed Amortization vs. Fixed Annuitization for Early Withdrawals From Your Self-Directed IRA

Self-Directed IRAYou probably already know taking a distribution from your self-directed IRA before you reach retirement will generally trigger a 10% early withdrawal fee, in addition to any taxes that may be due. You may also be familiar with certain exceptions that allow you to make penalty free withdrawals, including those for certain medical expenses, educational expenses, or a down payment for first-time home purchase.

But there is also another, lesser-known provision that you have available, known as a series of substantially equal payments. While it is somewhat more complicated than the other exceptions, and requires a longer term financial commitment, it might be suitable for some individuals in particular circumstances.

This exception allows you to set up a program where you begin taking annual withdrawals from your self-directed IRA prior to reaching age 59 1/2. The schedule of payments can be calculated by either a fixed annuitization method or a fixed amortization method, or the more familiar required minimum distributions method.

Fixed Annuitization. The fixed annuitization method provides the starting account balance by a factor taken from the IRS tables, which is based on mortality rates and a “reasonable” interest rate that cannot be less than 120% of the federal midterm rate. Essentially this method calculates the present value of a $1 per year lifetime annuity of a particular amount for the account holder, and divides this amount by the account balance to determine the annual payout.

Fixed Amortization. This method simply amortizes your account balance over your life expectancy. In general, the fixed amortization method yields a lower annual payment than the fixed annuitization method. When determining the “life expectancy” in the fixed amortization method, the account holder can either choose the calculation based on their life, or the joint life expectancy of themselves and their primary beneficiary.

It’s important to note that once this amount is calculated, it will not change. This means that an account that suffers significant investment losses may be depleted early, while an account that performs particularly well might have a surplus of funds.

Required Minimum Distributions. The third method of setting a schedule of substantially equal payments is to use the required minimum distributions method that applies to traditional self-directed IRA holders once they reach age 70 1/2. The biggest difference between this method and the fixed amortization and fixed annuitization methods discussed above is that the required minimum distributions are recalculated every year based on your current account balance.

You are allowed to change between these methods one time during the course of your life.

Once you begin taking substantially equal periodic payments from your self-directed IRA, you must continue to do so for at least five full years, or until you reach age 59 1/2, whichever is later. Therefore, this is not a one-time decision, and not a step to be taken lightly. It might be appropriate for your individual situation, but make sure you understand all the implications before moving forward.

2 thoughts on “Fixed Amortization vs. Fixed Annuitization for Early Withdrawals From Your Self-Directed IRA

  1. I am 63 1/2 years old and I want to begin a Roth IRA for real estate transactions. I was referred by Ron LeGrand. It is unclear to me about distributions from a Roth. As an
    example I deposit $500 and my IRA takes $100 and makes an RE investment
    with a $20,000 profit in 30 days that goes back into my Roth IRA.

    I understand the $20,000 is now tax free forever in a Roth. When can I take
    a tax free distribution on the 20K that was an “arms-length transaction?” Is there a 5 year vesting limit before I can withdraw tax-free? Are there
    any permitted withdrawals prior to the withdrawal restrictions?
    Thank you
    Randall Lybarger

    1. Mr. Lybarger,

      The 5-year rule for Roth contributions is used to determine whether a withdrawal of growth will be tax-free as a “qualified distribution” from a Roth IRA. In order to be a qualified distribution, two requirements must be satisfied. First, under IRC Section 408A(d)(2)(A), the distribution must be made either: on/after the date the IRA owner turns 59 1/2; after death of the IRA owner, after becoming totally disabled, or for qualified first-time homebuyer expenses (up to a $10,000 limit and subject to other limitations). The second requirement, in addition to meeting one of the preceding tests, is that the distribution must meet the Roth contribution 5-year rule (also known as the “nonexclusion period” under IRC Section 408A(d)(2)(B)).

      The 5-year rule essentially states that five tax years must pass from when the first contribution is made to (any) Roth IRA, until a qualified distribution can be made. Because the measurement is based on tax years, this means that a contribution to a Roth IRA as late as April 15 of 2014 will still count as a contribution for the 2013 tax year (in essence, it counts as though the contribution was made January 1st of 2013), which means the first year of a potential qualified distribution would be 2018 (because the five years that passed would have been 2013, 2014, 2015, 2016, and 2017). Notably, this means that a “5-year” qualified distribution could actually be made after less than 3 years and 8 months, as a contribution on April 14 of 2014 (made in 2014 but for 2013) would allow for tax-free distributions as early as January 1st of 2018.

      The purpose of the 5-year rule on Roth contributions is relatively straightforward – to require that tax-free growth for retirement purposes be done for the long-term, which means the account must be maintained for at least 5 years (in addition to meeting one of the other requirements). It is important to note that Roth Conversion have their own 5 year clock which begin in the tax year for which each conversion was made.

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