July 2004 On-line Tax Planning

Withdrawing Money From Your Retirement Account

Before we begin this article, we need to start with a statement.  Never try to withdraw money from your retirement if you are under 59 ½ years old.  Between taxes on the income you receive and the 10% penalty, Uncle Sam will get such a healthy chunk of change that your head will spin all the way until April 15 of next year.

While not true in some cases, but in the vast majority of cases, premature distributions of retirement funds will cost you big.  There is, however, a way to withdraw those funds - if you follow the rules.

What gives you this power?  Internal Revenue Code (IRC) Section 72(t) gives you the ability to withdraw funds from your IRA or other qualified plans without penalty under certain circumstances.

Withdrawal on Account of Death
This particular assumption sort of leaves you out in the cold with respect to you benefiting from your retirement plans, so suffice it to say that your heirs may pay estate tax and will pay income tax on withdrawals from your IRA, but they needn’t worry about an added 10% penalty.

Withdrawal on Account of Disability
Funds distributed from your plan because you become disabled will not be assessed a 10% penalty.  To meet the exception, you must meet the following requirements.

Withdrawal That is Part of a Series of Equal Periodic Payments
The IRC allows you to withdraw from your qualified retirement account an amount that would result in you receiving substantially equal payments over your lifetime.  For purposes of computing these payments, you would use the life expectancy tables published by the IRS.

Obviously, if you are in need of a substantial amount of cash, this option won’t work for you.  If, on the other hand, you need only a small amount to meet your needs, a plan based on this exception may be for you.

Suppose you start the withdrawals and later determine that’s not what you wanted to do.  Can you back out of the deal?  Not without incurring a penalty you can’t.  There are two exceptions to this general rule.  If you are over 59 ½, all bets are off and you won’t have to pay the penalty.  If you make the payments for at least the five-year period beginning with the date of the first payment you may be able to change the terms of the withdrawals without penalty.  You can use the five-year exception if the ending date of the fifth year is after you reach 59 ½.  If you don’t meet these exceptions, you will pay the 10% penalty plus interest on all of the withdrawals.

Withdrawal After Age 55 and After Termination From Your Job
There is some good news if you received a lump-sum payment from your former employer after being laid off.  If you are age 55 or older, distributions from a qualified plan are not assessed the 10% penalty.

Withdrawal to Pay Deductible Medical Expenses
This little exception has one very big trap hidden in it.  When Congress says you can exclude from penalty any distributions made to pay deductible medical expenses, they mean it.  The trap is that only withdrawals from a qualified plan or IRA made to cover those medical expenses in excess of 7½ percent of your adjusted gross income can be excluded from the penalty calculation.  Be careful if you chose to use this exception.

Withdrawals Paid to an Alternate Payee
In divorce situations, a Qualified Domestic Relations Order (QDRO) may be filed.  Basically, this allows a former spouse to receive some portion of a participant’s retirement account balance.  The participant will not be assessed a 10% penalty in this situation.  QDRO rules apply only to qualified plans, but not IRAs.

Withdrawals to pay Higher Education Expenses
This exception applies only to IRAs.  You can withdraw money from your IRA to pay qualified higher education expenses.  Generally, these include tuition, fees, supplies and equipment needed to enroll in or attend a qualified institution.  If the student is enrolled at least half-time, room and board charges are also considered qualified expenditures.  If your student lives off campus and not at home, then the maximum allowable room and board charge to use in the calculation of excludible income is $2,500.

Withdrawal for use by First-time Homebuyers
If you have not owned a home in the last two years, you can withdraw up to $10,000 penalty-free to help pay for the home. This exception only applies to IRAs.

Conclusion
There are several other exceptions to the 10% penalty on withdrawals from a qualified retirement plan or IRA, but we have discussed the more common types.  There are also many details that must be addressed.  Therefore, be certain you meet the requirements to avoid penalty if that is possible in your situation.  Also, be sure you have no other sources of cash before withdrawing funds from an IRA or qualified retirement plan.  

If you have questions or need help, we are just a phone call away.

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