Avoid the 10% Early Withdrawal Penalty – What every Traditional IRA owner should know

Avoid the 10% Early Withdrawal Penalty – What every Traditional IRA owner should know

While it is not a good idea to tap retirement accounts prior to retirement age, sometimes it cannot be avoided. What can often be avoided, however, is the punitive 10% penalty for early fund distributions. Outlined here are exceptions to the 10% penalty rule for Traditional IRAs.

It is one thing to be taxed on retirement contributions and their related earnings when you withdraw funds from your Traditional IRA, it is quite another when you pay the tax PLUS a 10% penalty for early withdrawal. Need funds prior to retirement and want to avoid the early withdrawal penalty? There are cases when this can be done:

  1. Medical insurance premiums if unemployed. If you receive federal or state unemployment for 12 or more consecutive weeks, you may pay for medical insurance premiums from your Traditional IRA without paying the 10% early withdrawal penalty. The premiums may cover yourself, your spouse, and your dependents’ medical insurance premium.
  2. Qualified higher education expenses. You may pay for tuition, books, fees, supplies, and equipment at a qualified post-secondary institution for yourself, your spouse, your child or grandchild from your Traditional IRA without paying the 10% penalty.
  3. Medical expenses. If you need to withdraw from your IRA to fund medical expenses in excess of 10% of your adjusted gross income you may do so penalty-free.
  4. First-time home buyer. IRA distributions of up to $10,000 to help pay for the qualified acquisition costs of a first-time home avoid the early withdrawal penalty too. This is a lifetime limit per individual. A first-time homebuyer is defined by the IRS as not having an ownership interest in a principal residence for two years prior to your new home acquisition date. To qualify the home can be for you, your spouse, your child, your grandchild, your parent or even other ancestors.
  5. Conversions of Traditional IRAs to Roth IRAs. Want to convert your Traditional IRA into a Roth IRA to avoid paying taxes on future account earnings? No problem, this too is considered a qualified event to avoid the 10% penalty.
  6. You’re the beneficiary. If you are the beneficiary of someone else’s IRA and they die, there is usually an opportunity to withdraw funds without the penalty. Plenty of caution is required in this case, because if treated incorrectly the penalty might apply.
  7. Qualified reservist. If you were called to active duty after 9/11/2001 for more than 179 days, amounts withdrawn from your IRA during your active duty can also avoid the 10% penalty.
  8. Annuity distributions. There is also a way to avoid the 10% early withdrawal penalty if the distributions “are part of a series of substantially equal payments over your life expectancy.” This option is complicated and must use an IRS-approved distribution method to qualify.

Some Final Thoughts

  • Remember, the above ideas help you avoid an early withdrawal penalty for funds taken out of your Traditional IRA prior to reaching the age of 59 ½. After this age, there is no early-withdrawal penalty. The penalty is also waived if you become permanently or totally disabled or use the funds to pay an IRS tax levy.
  • While the above events allow you to avoid the 10% early withdrawal penalty you will still need to pay the income tax due on the withdrawn funds.
  • While generally the same, the 10% early withdrawal penalty rules are slightly different for defined contribution plans like 401(k)s and other types of IRAs.
  • Before taking any action, call to have your situation reviewed. It is almost always better to keep funding your Traditional IRA until you retire.

 

There’s Still Time to Fund Your IRA

There’s Still Time to Fund Your IRA

Looking for a last minute way to reduce last year’s taxable income? Consider funding a Traditional IRA or Roth IRA. Here is what you need to know

Remember that you have until you file your tax return to make a contribution to a Traditional IRA or Roth IRA for the 2016 tax year. The annual maximum contribution amount is $5,500 or $6,500 if you are age 50 or over.

However, if you or your spouse are an active participant in an employer’s qualified retirement plan, you may not be able to contribute the maximum amount. It depends on whether your modified adjusted gross income (MAGI) exceeds certain income thresholds. The limits for both Traditional and Roth IRAs are:

2016

2016 IRA Contributions

Note: Married IRA limits depend on whether either you, your spouse or both of you participate in a qualified employer provided retirement plan. If married filing separate and either spouse participates in an employer’s qualified plan, the income phaseout to contribute is $0 – $10,000.

How does the phase out work?

If your income is below the “full contribution” amount noted above, you can contribute up to the maximum annual contribution. If your income is above the “phase out complete” amount, you cannot make tax-advantaged contributions separate from your employer plan.

If your income falls between these ranges, this is how you calculate the reduced amount you can contribute:

  1. Subtract your income from the higher (phase out complete) amount to get your contribution income potential.
  2. Next calculate the phase-out range.
  3. Divide your contribution income potential by the phase-out range.
  4. Take the result times your maximum annual contribution amount.

Example: Roth IRA contribution limit for a single person, age 40 with MAGI of $122,000; $10,000 contribution income potential (132,000-122,000); divided by phase-out range of $15,000 ($132,000 – 117,000); 10,000/15,000= .666 x $5,500 = $3,663 2016 ROTH IRA contribution limit. Rounding rules apply.

If it’s too late for you to make a 2016 contribution, it’s not too late to plan for 2017. Here are the limits for 2017.

2017

2017 IRA Contributions

A final thought

If your income is too high to take advantage of these IRAs you can always make non-deductible contributions to a retirement account. While the contributions are taxed, tax on the earnings is deferred until they are withdrawn.

Indirect IRA Rollovers. Change is Coming

Indirect IRA Rollovers. Change is Coming

A recent Tax Court ruling makes the use of indirect rollovers from one IRA to another a risky proposition. To ensure no trouble with the IRS, rollovers of this type should probably be handled directly by financial trustees. Here is what you need to know.

Topline: When rolling over funds from one IRA to another (typically Traditional IRAs, Roth IRAs, SEP IRAs and Simple IRAs), it is best to use a direct rollover versus an indirect rollover. As confirmed in a recent tax court ruling, taxpayers are limited to ONE INDIRECT rollover per 12 months. This limit applies no matter how many IRA accounts you own.

Background

Many taxpayers have numerous Individual Retirement Accounts (IRAs). You can move funds from one qualifying account to another without paying taxes on the rollover as long as you follow the rollover rules. If the rules are not followed, the funds are deemed a distribution and taxes plus a potential early withdrawal penalty may be owed. There are two primary methods for rolling over the funds from one account to another:

Direct Rollover. Using this method, the taxpayer never takes possession of the rollover funds. Instead, one institution transfers the funds out of one account and sends them directly to the institution that has the receiving account. Since the taxpayer never takes possession of the funds, there is little chance the IRS would see the transfer as a distribution.

Indirect Rollover. In this case, the funds are withdrawn from the IRA and sent to the account holder. The account holder then deposits the same amount into the new account. As long as the transfer takes place within 60 days, it is a valid transfer and no taxes are owed. The taxpayer bears the burden of proof that the transfer was completed within the required timeframe.

Aggregate once per year rule

In a recent court case, the IRS put their foot down on unlimited INDIRECT transfers of funds.* In their ruling they stated that a taxpayer is entitled to make one indirect transfer per 12-month period regardless of the number of IRA accounts. Any additional transfers are not valid and will be deemed a distribution from your IRA.

Why the rule?

Some taxpayers were using a number of rollovers of the same dollar amount from account to account to give themselves a short-term loan. In the tax case, the defendant removed funds from one IRA. He used the money for a couple of months. He then took the same amount from a second IRA and replaced the money originally removed from the first IRA. He then took the same amount from a third IRA to replace the funds in the second IRA. Finally, the last IRA had its funds replaced. Effectively giving him use of the funds for up to 120 days. The court ruling effectively eliminated the ability to make these kinds of transfers.

Effective change

The court ruling creates a change in the IRA indirect rollover rules beginning on January 1, 2015. Effective that date, you may only conduct one indirect IRA rollover per 12 month period. IRS publications will be revised to reflect this change.

Because of this, it is best to employ a direct rollover of funds from one IRA to another using a qualified financial trustee to avoid any potential problems. This ruling does not apply to all conversions and rollovers. Please contact the financial institution receiving the rolled over funds for details on their process to ensure it is handled correctly.

*Source: T.C. Memo 2014-21 Bobrow vs Commissioner IRS

Tax-Free Roth IRA Withdrawal Options

Tax-Free Roth IRA Withdrawal Options – What every Roth IRA account holder should know

While Roth IRAs are funded in after-tax dollars, making a mistake on fund withdrawal could still subject you to tax and penalties on withdrawal of earnings. Here are some tips.

You must take care to plan your retirement plan withdrawals to avoid a potential 10% early withdrawal penalty. Unfortunately, each retirement account type has different rules. Here are some tips for Roth IRAs.

Roth IRA basics

Roth IRA accounts differ from other IRAs in that your contributions are made in after-tax dollars. If you follow the Roth IRA rules, your withdrawals of any earnings in the account can be tax-free. Generally, to take advantage of the tax-free distribution from a Roth IRA:

  • You must be age 59 ½ or older.
  • You must have had funds in the Roth IRA account for more than 5 years.
  • You must understand what is being distributed (contributions, converted funds or account earnings).
  • You must know your possible tax-free distribution options.

If you do not comply with these rules you could be subject to income tax and a 10% early withdrawal (distribution) penalty. But wait! There are ways to avoid income tax and the early withdrawal penalty.

Roth IRA distribution tips

  • Remember contributions have been taxed. What many forget is that your initial contributions have already been taxed. The portion of your early distribution from a Roth IRA account subject to income tax is only the untaxed earnings on your contributions.
  • 10% early withdrawals. Early withdrawal penalties are subject to the five year account rule and how you use the funds when distributed. It also might depend on what funds you remove from your account. Prior to withdrawing funds, ask for help to ensure you know whether you will be subject to the early withdrawal penalty.
  • Qualified early withdrawals. If you use the distributions for a qualified reason, you can avoid the early distribution penalties. Some of the more common qualified early withdrawals with Roth IRA’s are:
    • College. If you withdraw Roth IRA earnings to pay for college expenses, you will pay tax on the earnings withdrawn, but you will not be subject to the 10% early withdrawal penalty.
    • First-time home buyer. Even if you’ve had your Roth IRA for less than five years, you can withdraw up to $10,000 in Roth IRA earnings income tax-free and penalty tax-free if it is used to buy a first home.
    • Account holder disability or death.
    • Unreimbursed medical expenses that exceed your itemized deduction threshold.
    • Substantially equal periodic payments. These must be made over the defined life-expectancy of the IRA holder using specific rules to avoid the early withdrawal penalty.
  • No minimum withdrawal requirements. Unlike other IRAs, the Roth IRA does not require you to take money out when you reach a certain age. With Traditional IRAs this withdrawal requirement occurs when you reach age 70 ½. This means you can have a strategy to never withdraw the funds in your Roth IRA as an estate-planning device. While the funds would be considered part of your estate, your heirs could withdraw the funds tax and penalty-free during their lifetime.
  • Keep separate accounts. The taxability of a withdrawal can be complicated. Are you withdrawing contributions, converted funds, or earnings? How long have the funds been in the Roth IRA? Because this can be complex, try to keep your Roth IRA accounts simple. If you convert funds from another retirement account into a Roth IRA, do so in a separate account. It will then be easier to understand the impact of a withdrawal from the account.

If you have questions regarding your situation, speak to a qualified planner prior to taking any withdrawals from a Roth IRA or other tax advantaged retirement plan. It could save you plenty in potential tax and penalties.

Take an IRA Deduction Now. Pay Later.

Want to reduce your taxable income using a tax deferred contribution to an IRA but don’t have the funds to do so? If you expect a tax refund, here is a technique that may help.

Here is a tax planning tip for those who file their tax returns early and wish to contribute to a tax deductible IRA, but do not have the funds to do so.

Say you want to pay into an IRA to get a tax break but you don’t have the money? Take heart, there are ways to get around this. The IRS allows you to take the deduction now and pay later when you get your refund.

How it works

Step 1: Prepare your tax return early in the year (early February). Run the tax return considering an income reducing contribution to a tax deferred IRA. If you do not have the funds to put into the IRA, but your tax return has a refund that can fund your contribution, you are ready for step 2.

Step 2: File your tax return with the IRA contribution noted. File the tax return as early as possible to ensure your refund gets back to you prior to April 15th. E-file the return if at all possible.

Step 3: Fund your IRA prior to April 15th. Tell your IRA investment firm you wish your IRA contribution to be for the prior year.

That’s it. You have now effectively had the income reduction benefit of your IRA contribution help fund the account through your tax refund.

The risks

Timing is everything. If you use this technique it is critical that the IRA is funded on or before April 15th. If it is not, your tax return will need to be amended.

Refund not received in time. If you do not receive your refund in time, you may not have the funds to make a timely IRA deposit. In this case, you may need to borrow funds on a short-term basis until the refund is received.

No extensions. The IRA contribution for the prior year must be made by April 15th of the following year (the original filing due date). This is true even if you file your return under an approved extension period.

While not for everyone, this tax tip could help you fund more of your retirement on a tax deferred basis.

Still Time to Make IRA Contributions for 2012

Remember you have until April 15th to fund last year’s IRA contributions. Here is what
you need to know.

Remember you have until you file your tax return to make a contribution to a Traditional IRA or Roth IRA for the 2012 tax year.  The annual contribution limit is $5,000 or $6,000 (if you are age 50 or over).  Prior to making the contribution, if you (or your spouse) are an active participant in an employer’s qualified retirement plan, you will want to make sure your modified adjusted gross income (MAGI) does not exceed certain income thresholds.  There are also MAGI (income) limits to qualify to make Roth IRA contributions.  The limits are:

2012 IRA contribution limits

Contribution limit: $5,000  or $6,000 (with age 50+ catch up provision)

Income limits:

2012 IRA Contributions

Note: Married Traditional IRA limits depend on whether either you, your spouse or both of you participate in a qualified employer provided retirement plan. If married filing separate and either spouse participates in an employer’s qualified plan, the income phase-out to contribute is $0 – $10,000.

How does the phase-out work?

If the phase-rules apply to you and your income is below the “full contribution” amount noted above, you can contribute up to the maximum annual contribution. But what if your income falls between these ranges?

1. First, subtract your income from the higher (phase-out complete) amount to get your contribution income potential.
2. Next calculate the phase out range.
3. Then, divide your contribution income potential by the phase-out range.
4. Take the result times your maximum annual contribution amount.
Example:  Roth IRA contribution limit for a single person, age 40 with MAGI of $115,000; $10,000 contribution income potential (125,000-115,000);  divided by phase-out range of $15,000 ($125,000 – 110,000);  10,000/15,000= .666  x  $5,000 = $3,300 2012 ROTH IRA contribution limit. Rounding rules apply.

If it’s too late for you to make a 2012 contribution, it’s not too late to plan for 2013. Here are the limits for 2013.

2013 IRA contribution limits

Contribution limit: $5,500 or $6,500 (with age 50+ catch up provision)

Income limits:

2013 IRA Contributions

Note: Married Traditional IRA limits depend on whether either you, your spouse or both of you participate in a qualified employer provided retirement plan. If married filing separate and either spouse participates in an employer’s qualified plan, the income phase-out to contribute is $0 – $10,000.

A final thought: If your income is too high to take advantage of these IRAs you can always make a non-deductible contribution to an IRA.  While the contributions are not tax-deferred, the earnings are not taxed until they are withdrawn.