Structuring IRA Distributions To Avoid Penalties - Safe Harbor Planning: A Few Helpful Methods
By Erina Array
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IRA distribution rules are a mine field. One incorrect move and you could discover yourself faced with high taxes and penalties that may wipe out years of savings and investment. Complicating issues is the Darwinian evolution of IRAs that have taken place since the first IRA was introduced in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA ). Since '74, IRA policy have altered dramatically and legislation was enacted to rigorously punish those who do not follow the rules, to the letter of the rule. IRAs come in a lot of flavors but, for purposes of this article we'll focus on the 2 key kinds of IRAs: Traditional IRAs and Roth IRAs.
Approaches for Minimizing Penalties on Early Distributions
Generally, any distribution from an IRA before you reach age 59 1/2 is considered an early distribution and is subject to a ten percent penalty on the taxable amount received in a distribution. There're particular IRA distribution rules that might be used to avoid the imposition of this early withdrawal penalty.
1. Using IRA Funds to Buy or Build Your First Home - Up to $10,000 may be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to purchase, construct or repair a first house for yourself, your spouse, you or your spouse's child, you or your spouse's grandchild or you or your spouse's parent or ancestor.
2. Using IRA Money for Medical Bills - Penalty-free early distributions could be made if the money are used to pay unreimbursed medical bills which exceed 7.5 percent of your adjusted gross income. There is no requirement to itemize deductions to be eligible for this exception.
3. Using IRA Funds for School Expenses - Traditional IRAs can also be tapped to help fund college costs; however, the taxable amount of the distributions from these IRAs shall be matter of income tax in the year of the distribution.
Roth IRA distribution rules
Roth IRAs have unique regulations with respect to distributions. Contributions withdrawn are not matter of the ten percent penalty and there is no RMD with Roth IRAs. In order for Roth IRA earnings distributions to be tax-free, the account must have been opened for five years and the distributions should be made after reaching age 59 1/2. If you fullfil the 5-year rule but not the 59 1/2 year rule, distributions in excess of your contributions might be taxable and subject to a ten percent penalty.
1. No RMD - With Roth IRAs, there is no RMD at age 70 1/2. This means a Roth IRA owner is never required to make a distribution out of their Roth IRA. Because of this, Roth IRAs can grow, untaxed, throughout the lifetime of the owner, allowing a larger legacy for their beneficiaries.
2. Zero Percent Effective Tax Rate - Qualified distributions from Roth IRAs aren't subject to income tax...ever. This means you are unaffected by future tax increases as your effective tax rate is always the same...zero.
3. Conversion Opportunities - Beginning after January 1, 2010 anyone, irrespective of their earnings level, may convert conventional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be delayed into 2011 and 2012. If you do not have sufficient money set aside to do a 100% conversion you can do partial conversions.
4. College Costs - Because Roth IRA contributions may be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child's academy expenses.
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