Most individuals know that if they withdraw funds from their traditional individual retirement account (IRA) before reaching the age of 59 1/2, they are subject to a 10% penalty in addition to having the withdrawal subject to income tax. For a taxpayer in a tax bracket as low as 15%, this means that 25% of the distribution will be paid to the IRS.
Those individuals who consult with an experienced tax professional for tax preparation and tax planning services before making such a withdrawal may be surprised to learn that they can avoid the 10% early withdrawal penalty.
First, only the taxable portion of withdrawals from a traditional IRA is subject to income taxes and the penalty. If a portion of your IRA balance consists of after-tax contributions, then a part of each withdrawal would be tax-free and penalty free. This illustrates the importance of maintaining accurate records of your IRA contributions over your lifetime.
There are also specific exemptions which can avoid the 10% penalty. Some of these exemptions include using the withdrawn IRA funds to pay for . . .
- Health insurance premiums if you have lost your job and collected 12 consecutive weeks of state or federal unemployment compensation, the distributions are received either in the year of unemployment or the following year, and the distributions are received no later than 60 days after you have been unemployed.
- Qualified higher-education expenses, such as college or vocational-school tuition for yourself, your spouse, your children or grandchildren, or your spouse’s children or grandchildren. When utilizing this higher-education exemption, it is important that the tuition is paid in the same calendar year that the IRA funds were withdrawn. Since these educational expenses can only result in one tax benefit, you will need to consider the impact of losing the educational tuition deduction or credit.
- Purchase, building or rebuilding a first home for yourself, children or grandchildren (dollar limitation applies).
- Unreimbursed medical expenses greater than 10% of your adjusted gross income (7.5% if you or your spouse was born before 1949).
- Anything if you are totally and permanently disabled which prevents you from any substantial gainful activity and a physician determines that your condition can be expected to result in death or be of a long, continued, and indefinite duration.
If you don’t qualify for one of the specific exemptions, you may be able to avoid the penalty by taking a series of substantially equal payments over your life (or your life expectancy), or over the lives (or the joint life expectancies) of you and your beneficiary. You must use an IRS approved distribution method and you must take at least one distribution annually. There are two other methodologies that can be used which IRS Publication 590 states are very “complex and generally require professional assistance.”
What if your IRA is a Roth? With a Roth IRA, contributions are made with after-tax money, and for those over 59½ who have had the account for at least five years, withdrawals aren’t taxable. Before the five-year period is over, the earnings portion of a withdrawal is subject to income tax. But if you’re younger than 59½, even if you pass the five-year test, the earnings portion of a withdrawal may be subject to taxation, plus a 10% penalty if you don’t qualify for an exception. The exceptions are the same as those for a traditional IRA, including withdrawals used for qualified higher education or a first-time home purchase, for health-insurance premiums if you are unemployed, or if you become disabled before age 59½. Since the money withdrawn from a Roth is treated as coming from contributions first, you won’t owe any tax or the penalty as long as you take out less than you’ve put in. Again, this illustrates the importance of keeping good records.
Since the financial institution making the distribution from your IRA will send you and the IRS a Form 1099-R showing the amount of your distribution and a code showing that it is an early distribution subject to the 10% penalty, the IRS will be matching your tax return to that Form 1099. For the distribution to be penalty-free, you need to file Form 5329 with your federal income-tax return indicating which exception you are claiming. As with any item on your tax return, the IRS may request substantiation to support your claimed exemption.
If you want to learn more about the various IRS exemptions to avoid the 10% early withdrawal penalty, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA officeto discuss your situation. You can also schedule a consultation at Click Here.
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