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Not Understanding IRA Distribution Rules Can Be
Expensive

Jack, who is 40 years old, wants to withdraw money from his traditional IRA because he suffered an accident, is disabled and needs the money.

Is he eligible?

Mike, who just turned 70 ½, can withdraw $5000 from his IRA, but decided to only take $2000, thinking that he would save the balance.

Will he face a penalty?

To answer these questions, I really had to do some research into IRA distribution rules.

First of all, the IRA distribution rules for IRAs that are individually owned vary from those sponsored by an employer.

In fact, you already know that there are two kinds of IRA - the traditional IRA and the Roth IRA. You know a Roth IRA is treated is differently from other IRAs.  After I started looking into this subject, I found out that there is no such thing as a standard explanation for IRA distributions, which makes it even more complicated.

IRA distribution rules depend on how old you are at the time the distributions begin, as well as how you take the money. You could save tax, or you could end up with a huge tax liability of almost 50 percent. That’s a pretty big difference! To avoid expensive errors, you have to know the IRA distribution rules when you do your retirement investment planning.

IRA withdrawals

First, let’s look at how you can get your money out of a traditional IRA. Traditional IRA contributions are tax deductible and subject to your income and your participation in a plan sponsored by your employer. When you get a distribution, you are liable to pay tax.

To make a long story short, it all boils down to how old you are when you withdraw the money. It is a bad idea to withdraw before you are 59 ½ years old, and an equally bad idea if you do not withdraw enough when you turn 70 ½. If you withdraw before you are 59 ½, you are slapped with a ten percent penalty on the taxable amount, apart from the income taxes you would normally have to pay in your bracket. The issuing company for your IRA fund will also charge you surrender charges.

There’s good news, too, though, in the form of exceptions. You can make penalty-free withdrawals from your traditional IRA before you are 59 ½ in the following situations:

  • Your beneficiaries withdraw after your death
  • You are disabled
  • You use the money to pay medical expenses that are over seven-and-a-half percent of your adjusted gross income
  • You are unemployed and you need the money for health insurance
  • You use the money for higher education
  • You use the money for a first-time house purchase for yourself (limited to $10,000)
  • You withdraw an excess contribution

The answer to Jack’s question, then, is yes. Although he is under age 59 ½, he is disabled, so he is eligible to withdraw without penalty.

These are just some of the exceptions, and you would need to check with your financial adviser to know where you stand depending on your situation.

If you are 70 ½, you have to start withdrawing minimum distributions; if not, you face huge penalties. You face a 50 percent penalty on the difference between what you should have withdrawn and what you actually withdrew. To illustrate: If you were supposed to take $5000 during that particular year based on your required minimum distribution calculation, but instead only took $2000, you have to pay a penalty of $1500, or 50 percent of the undistributed $3000! This answers Mike’s question – he definitely does not want to withdraw less than his minimum requirement.

What about Roth IRA distribution rules?

Getting your money from a Roth IRA is different from the traditional IRA. The contributions are non-deductible since you make them with after-tax dollars. You can withdraw contributions whenever you want and Uncle Sam will not ask any questions. You can continue to contribute after you are 70 ½, letting the money accumulate throughout your life. While qualified distributions are tax-free, non-qualified ones attract a penalty of ten percent plus income tax. Also, in order to withdraw from a Roth IRA penalty-free:

  • Your money should have been there for at least five years
  • You should be 59 ½ or older
  • If you are under 59 ½, you must be disabled
  • The distribution may be made to your beneficiaries after your death
  • You must use the money to buy your first home (limited to $10,000)

Now that you have an idea of the various factors that influence your IRA withdrawal, all you have to do is consult your tax advisor based on your specific circumstances.

 

Return from IRA Distribution Rules to Individual Retirement Account

 



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