Posted by Jordon Rosen CPA, MST, AEP®
Stashing away the maximum amount into your IRA each year is retirement planning rule 101. But what happens if you find you need to tap those funds before you retire to pay for living expenses, education, or a medical emergency?
Distributions from a traditional IRA, other than the portion representing after-tax contributions, are taxed as ordinary income. With certain exceptions, the taxable portion of the distribution taken prior to age 59½ is also subject to a 10% penalty. The following is a list of those exceptions, several of which also apply to early distributions from employer retirement plans.
Rollovers: The penalty does not apply to the portion of the distribution that is rolled over to another qualified plan within 60 days of the distribution. If the 60-day period is missed, Revenue Procedure 2016-47 provides individuals with the requirements and a model letter for self-certification for obtaining a waiver from the penalty, subject to IRS review and approval.
Death: The penalty does not apply if you are taking the distribution as the beneficiary of a decedent’s IRA account. Surviving spouses under the age of 59½, who have the option to roll the entire balance of a deceased spouse’s account into their own IRA should be careful in doing so in case they need to take funds out prior to their reaching age 59½ and subjecting the distribution to the 10% penalty. They should consider keeping a portion of the deceased spouse’s IRA in a beneficiary IRA since distributions from those accounts are not subject to the penalty.
Disability: The penalty does not apply if distributions are made due to total and permanent disability of the IRA owner.
Qualified Education Expenses: Qualified expenses include tuition, fees, books and supplies for you, your spouse, children and grandchildren. Room and board qualify if the individual is at least a part-time student. Be careful here – distributions from IRAs are considered income and could impact financial aid eligibility.
Equal Payments: The penalty does not apply if payments are made in a series of substantially equal payments. This is a tricky computation and professional tax advice should be sought out on this.
First-time Homebuyers: The penalty does not apply on distributions up to $10,000 by first-time homebuyers to pay for qualified expenses for yourself, child, grandchild or ancestor. The funds must generally be used within 120 days and the individual must not have had any home ownership within the past 2 years.
IRS Levy: The penalty does not apply to distributions taken because of an IRS levy of the plan.
Payment of Medical Expenses: The penalty does not apply to the amount of unreimbursed medical expenses, not to exceed the allowable deductible amount (above the 10% of AGI threshold).
Health Insurance Premiums: The penalty does not apply to distributions taken to pay health insurance premiums while unemployed for at least 12 consecutive weeks.
Military Service: Certain distributions to qualified military reservists called to active duty will not be subject to the penalty.
Divorce: Qualified Domestic Relations Orders (QDROs) do not apply to IRAs. However, a court can incorporate a provision in the divorce or separation agreement that all or a portion of an individual’s IRA account be transferred to his/her spouse or former spouse. This should not be done as a distribution to the IRA owner followed by a contribution to the spouse’s account as such a transaction would be taxable and possibly subject to penalty if the owner is under age 59½.. A trustee-to-trustee transfer will not be considered as a distribution, thus neither taxable nor subject to the early distribution penalty.
If you have questions or want further information on the above or other income, retirement or estate planning techniques, please contact Jordon Rosen at firstname.lastname@example.org.