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Individual Retirement Accounts (IRAs) distribution rules are a mine field. One wrong move and you can find yourself faced with high taxes and penalties that can wipe out years of savings and investment. Complicating matters is the Darwinian evolution of IRAs that have taken place since the first IRA was introduced in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA ). Since 1974, IRA rules have changed dramatically and legislation was enacted to severely punish those who do not follow the rules, to the letter of the law.
IRAs come in many flavors but, for purposes of this article we will focus on the two main types of IRAs: Traditional IRAs and Roth IRAs.
Strategies for Minimizing Penalties on Early Distributions
Generally, any distribution from an IRA before you reach age 59 ½ is considered an early distribution and is subject to a ten percent penalty on the taxable amount received in a distribution. There are specific distribution strategies that can be used to avoid the imposition of this early withdrawal penalty.
1. Using IRA Money to Buy or Build Your First Home – Up to $10,000 may be withdrawn from an IRA as an early distribution penalty-free, as long as the distribution is used to buy, build or rebuild a first home for yourself, your spouse, you or your spouse’s child, you or your spouse’s grandchild or you or your spouse’s parent or ancestor. A first-time homebuyer is one with no present ownership interest in a home during a two year period ending on the date of acquisition of the home the distribution is being used to buy, build or rebuild.
2. Using IRA Money for Medical Expenses – Penalty-free early distributions can be made if the funds are used to pay unreimbursed medical expenses which exceed 7.5 percent of your adjusted gross income. There is no requirement to itemize deductions in order to qualify for this exception.
3. Using IRA Money for College Costs – Traditional IRAs can also be tapped to help fund college costs; however, the taxable amount of the distributions from these IRAs will be subject to income tax in the year of the distribution. The education must be for you, your spouse or the children or grandchildren of you or your spouse. Qualified educational expenses include tuition, fees, books, supplies, equipment and room and board of a student enrolled at least half-time.
4. Using IRA Money to Pay for Health Insurance – If you experienced a job loss you can take an early distribution, penalty-free, provided you use the money to pay for health insurance. To qualify for this exception, the distribution cannot exceed your cost of your medical insurance in a year in which you lost your job and you are the recipient of unemployment compensation for twelve consecutive weeks due to the job loss.
5. Using IRA Money When Permanently Disabled – There is no ten percent penalty for an early withdrawal if you need the money due to a permanent disability. In order to qualify the disability must be either life threatening or chronic (indefinite duration). The disability must be certified by a physician.
6. Inheriting an IRA – If you are the beneficiary of an IRA and you are under age 59 ½, no part of the RMD will be subject to the ten percent penalty and you may be able to stretch the RMD over your life expectancy.
7. Annuitizing – You can take early distributions before age 59 1/2 in the form of a series of substantially equal periodic payments over your life expectancy. This is known as the 72(t) Exception. You can begin a 72(t) distribution strategy at any age. There is no required starting age. Lastly, you can execute this distribution strategy even if you are still employed.
8. Using IRA Money to Fund Health Savings Accounts – The 2006 Tax Relief and Healthcare Act allows IRA owners a one-time transfer of funds tax-free from a traditional IRA directly into a health savings account (HSA). As long as the owner uses the HSA funds for out-of-pocket qualified medical expenses, these distributions are tax-free, penalty-free.
9. Active Reservist Exception – A qualified reservist is one who was called to duty after September 11, 2001 for active duty of more than 179 days or for an indefinite period.
10. Direct Transfers – Trustee to trustee direct transfers of funds from one IRA to another IRA are never subject to the ten percent penalty.
11. Qualified Rollovers – There is no penalty on the rollover of distributions received from an IRA as long s those funds are moved into another IRA within sixty days of the receipt the initial distribution. Any taxable amount not rolled over within this sixty day period must be included in income and may be subject to a ten percent penalty on the taxable amount not rolled over. IRA funds can only be rolled over once every 365 days. There is no penalty relief when the “once-per-year” rule is violated.
12. Net Unrealized Appreciation (NUA) for Terminated Employees – Individuals who have been terminated from their jobs and who have qualified retirement plans that include large amounts of appreciated employer stock have a unique opportunity to move that stock out of their retirement plan and into a taxable brokerage account, rather than rolling their entire retirement account into an IRA. Moving the stock into this taxable account constitutes a lump-sum distribution which is subject to ordinary income tax on the cost basis of the stock. Once the stock is moved into the brokerage account it can be sold at any time. You will owe tax on the sale at the favorable long-term capital gains tax rates (currently 15%). The taxable gain is equal to the difference between the fair market value of the stock on the date of the sale less the cost basis of the stock.
Strategies for Minimizing RMD Penalties
RMDs must be made no later than on April 1st of the year after you turn age 73, beginning in 2023. Failure to make a RMD subjects this RMD to a 50% penalty.
1. Second Year RMD – If you defer your first RMD to the April 1st date, you still have to take your RMD for the second year. Thus, you will have two RMDs in that first year. It is easy to forget to take this second year RMD and face a 50% penalty on your second year’s RMD.
2. Inheriting an IRA – When a beneficiary inherits an IRA, RMDs must begin no later than by the end of the year following the year of death of the IRA owner-decedent. Under the Secure Act 1.0 you have 10 years to distribute 100% of the Inherited IRA. Failure to make a RMD will subject that RMD to the 50% penalty.
3. Penalty Waiver – The 50% penalty can be waived by making up any missed RMDs and requesting a waiver from the IRS on form 5329. The penalty no longer has to be paid first, before receiving the waiver.
4. Conversion of Traditional IRA to Roth IRA – By converting your traditional IRAs into Roth IRAs, you can forever avoid RMD penalties as there are no RMDs with Roth IRAs.
Roth IRA Distribution Strategies
Roth IRAs have unique rules with respect to distributions. Contributions withdrawn are not subject to the 10% Early Distribution Penalty and there is no RMD with Roth IRAs. In order for Roth IRA earnings distributions to be tax-free, the account must have been opened for five years and the distributions must be made after reaching age 59 ½. If you meet the five-year rule but not the 59 ½ year rule, distributions in excess of your contributions will be taxable and subject to the 10% Early Distribution Penalty.
1. No RMD – With Roth IRAs, there is no RMD at age 73. This means a Roth IRA owner is never required to make a distribution out of their Roth IRA. As a result, Roth IRAs can grow, untaxed, during the lifetime of the owner, permitting a larger legacy for their beneficiaries.
2. Zero Percent Effective Tax Rate – Qualified distributions from Roth IRAs are not subject to income tax – ever. This means you are unaffected by future tax increases as your effective tax rate is always the same. for Roth IRAs – zero.
3. Conversion Opportunities – Beginning after January 1, 2010 anyone, irrespective of their income level, may convert traditional IRAs into Roth IRAs. You will need to pay the tax on any conversion with money coming from outside the converted IRA, such as a bank account. If you do not have enough money set aside to do a 100% conversion you can do partial conversions.
4. College Costs – Because Roth IRA contributions may be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child’s college expenses.
Tom Corley is an accountant, financial planner and author of “Rich Kids: How to Raise Our Children to Be Happy and Successful in Life”, “Effort-Less Wealth”, “Change Your Habits Change Your Life”, “Rich Habits Poor Habits” and “Rich Habits: The Daily Success Habits of Wealthy Individuals.”