Julie Welch Penalties generally apply if you withdraw money from your retirement plan before you reach age 59 ½. The penalty is 10% of the taxable distribution. The penalty is 25% if you take a distribution from a SIMPLE retirement plan within two years of becoming a participant.

Example:

You are 40 years old, receive $10,000 from your traditional IRA, are in the 28% Federal tax rate bracket, and do not meet any of the exemptions to the penalties. You owe the following tax and penalty:

Income tax at 28% tax rate            $2,800

Early distribution penalty            1,000

You can avoid the penalty if:

- You receive a distribution from your retirement plan or IRA, and you are totally and permanently disabled.

- You are at least 55 years old and receive a distribution from a retirement plan upon termination of employment. This exemption does not apply to distributions from IRAs.

- You receive a distribution as a beneficiary of an estate after the death of someone else.

- You receive a distribution from your IRA that you use to pay qualified first-time homebuyer expenses. This exception only applies to distributions from IRAs

- You begin receiving annual distributions from your IRA that you will receive over your life expectancy or the joint life expectancy of you and your spouse. This exception applies only to distributions from traditional IRAs unless the distributions are from your company’s retirement plan and start after you retire.

- You receive a distribution from your IRA that you use to pay medical expenses in excess of 7.5% of your adjusted gross income.

- You receive a distribution from your IRA that you use to pay qualified higher education expenses.

Qualified higher education expenses include expenditures:

- For tuition, fees, books, supplies, and equipment required for enrollment or attendance

- At a postsecondary educational institution, including graduate-level courses

- For you, your spouse, your child, or your grandchild

Qualified first-time homebuyer expenses include expenditures:

- Up to $10,000 during your lifetime

- For amounts used within 120 days to buy, build, or rebuild a principal residence for a first-time homebuyer, including any usual or reasonable settlement, financing, or other closing costs

- For you, your spouse, your child, your grandchild, or an ancestor of you or your spouse

You can be a first-time homebuyer even if you have previously owned a home. To be considered a first-time homebuyer, you (and your spouse if you are married) may not have owned a home during the previous two years.

Example:

In 2010, you and your spouse sell your home and move into an apartment. In 2014, you buy a new principal residence. You withdraw $6,000 from your traditional IRA to use for financing costs and closing costs. You will not have to pay the 10% early distribution penalty on your IRA withdrawal.

Additionally, generally the income tax and early distribution penalty do not apply if you roll over your distribution to another qualified plan or IRA within 60 days.

If you take another nonqualified distribution from your Roth IRA that you funded with Roth IRA contributions, you may still avoid the 10% early distribution penalty if the distribution is not taxable to you. However, if you convert a traditional IRA to a Roth IRA, and within five years take a distribution, the 10% early distribution penalty could apply even if the distribution is tax-free to you.

Example:

You are 50 years old and made Roth IRA contributions of $2,000 per year for four years, giving you $8,000 ($2,000 x 4) of basis in your Roth IRA. You take a $5,000 distribution. Since you have at least $5,000 of basis from making Roth contributions, the $5,000 is tax-free to you. Additionally, since no amount is taxable to you and since the distribution was entirely attributable to annual contributions you made, the 10% early distribution penalty will not apply.

 

If instead you made a Roth IRA conversion of $8,000 two years ago, the full $8,000 was taxed to you at the time. If you made no other Roth IRA contributions, you would still have $8,000 of basis in your Roth IRA. A $5,000 distribution would be tax-free to you. However, since the conversion amount is distributed within the five-year period of when you made the conversion and the distribution is nonqualified, you will pay a $500 ($5,000 x 10%) early distribution penalty.

NOTE: Distributions from your traditional deductable or nondeductible IRA may be subject to income tax even though they are not subject to the early distribution penalty. Generally distributions from Roth IRAs will be totally tax-free.

NOTE: The rules for distributions from SIMPLE retirement plans are different. See Internal Revenue Service Publication 590, available by calling 1-800-TAX-FORM.

 

Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.

 

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