Tuesday, October 15, 2013

Penalty-free IRA Withdrawals Are Possible, If...

Traditional individual retirement accounts, IRAs, are a good way to save for retirement. When times get tough, however, and you need some extra cash, it can be tempting to withdraw some of this money before the minimum age of 59 1/2. This is almost always a bad idea, unless you are up against a wall and have exhausted every other option.

If you withdraw money from your IRA before age 59 1/2, you will generally have to pay a 10 % early withdrawal penalty in addition to income tax on the amount withdrawn. And if it's a company sponsored Simple IRA within the first 2 years the plan has been opened that penalty goes up to 25%!

Once you turn age 59 1/2, you can withdraw any amount from your IRA without having to pay the 10 percent penalty. But regular income tax will still be due on each withdrawal. IRA distributions are not required until after age 70 1/2.

Exceptions to the Early-Withdrawal Rules

The Internal Revenue Service authorizes certain exceptions to these early-withdrawal rules. You still have to pay income taxes on the money withdrawn, but you can avoid paying the penalty. 

College costs - Higher education expenses for you, your spouse, and the children or grandchildren of you or your spouse. Qualifying expenses include tuition, fees, books, supplies and equipment required for attendance. If a student is enrolled at least half-time, room and board costs qualify. (Such distributions count as income, however, and could affect financial aid eligibility.) 
Un-reimbursed Medical Expenses - Medical expenses that are not covered by insurance and that are more than 7.5 percent of your adjusted gross income. This includes bills for you, your spouse and your dependents. For example, if your adjusted gross income is $100,000 and your un-reimbursed medical expenses are $10,000, the maximum amount that you can distribute penalty free is $2,500, which is the difference between $10,000 and 7.5% of your AGI ($7,500). Your tax professional will be able to help you determine your AGI.

Health insurance - IRA distributions can be taken without penalty to pay for health insurance for you, your spouse and your dependents following a period of unemployment. To qualify, you need to receive unemployment compensation for 12 consecutive weeks due to job loss. The distribution must be taken in the year you received the unemployment compensation or the following year, and no later than 60 days after you have been reemployed.

First time home purchase- Costs to buy, build or rebuild a first home. A “first time” homebuyer is defined as someone who hasn’t owned a home in the past two years, but this exception can be used only one time. For an individual, the amount is $10,000. If both spouses are first-time buyers, the limit is $20,000. Once withdrawn, the money must be spent or returned to the IRA within 120 days. 

Disability - If you become disabled to the point that you cannot participate in gainful activity due to your physical or mental condition, you can quality for an exemption to the early withdrawal penalty. But be prepared to prove it. "To qualify for this exception, you need a note from a physician confirming that your disability prevents you from doing any “substantially gainful activity” and that your condition is permanent. 

Military service - Members of the military service can take distributions without paying a penalty if they were ordered or called to active duty after Sept. 11, 2001, for a period of more than 179 days or for an indefinite period. The distribution must be taken during the active duty period. 

Inheritance - If you die before age 59 1/2, your traditional IRA can be distributed to a beneficiary or your estate without incurring the 10 percent penalty. Your beneficiary cannot roll over the IRA into their own name without paying a penalty.  However, if a spouse inherits the IRA and elects to treat it as his or her own, it may become subject to the 10 percent penalty. If the spouse is under age 59 1/2 and they think they will need the money before age 59 1/2, I would leave it as the inherited IRA, if that spouse rolls it over to their IRA; they are subject to the 10 percent penalty.

The issues surrounding early withdrawals from traditional IRAs can be complicated and each situation is unique. This piece provides a brief overview of the subject and is not intended as tax advice.

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