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Recent articles by Jeff Schnepper: • Hey, Jeff, can I deduct my truck?, 8/3/2004 • Hiring a maid? Hire an accountant, too, 7/20/2004 • How the tax code makes singles suffer, 6/22/2004 More... |
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| How to tap your nest egg penalty-free | |||||||||||||||
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Your IRA can be helpful in an emergency, and you can avoid the 10% bite for taking money out early. But youll still owe income taxes on any withdrawal. By Jeff Schnepper Sometimes, you just need the money now! You might have a sick child, lost your job or finally found the house of your dreams. Unfortunately, you listened to all those experts who demanded you put your investment dollars into an IRA first, and thats where all your cash is trapped. If its a traditional IRA, you got the deduction when you put the money in and expect to pay a tax when you take the money out. Thats only fair. But theres that 10% penalty that slams you if you take IRA distributions prior to age 59. Technically, the IRS calls that a premature distribution. Youd report the penalty on Form 5329 when you file your annual 1040. But there are ways to jump the pond and grab your cash, without the additional 10% hit, even if youre not yet 59. Heres how. Borrow it using the 60-day rule The rule on borrowing from an IRA is simple on the surface: You cant borrow money directly from your IRA. You cant even use your IRA as collateral for a loan. But, you can back-door borrow. You do it with the 60-day free rollover allowance. Lets say youve got $100,000 in your IRA. Even if you take out the money, you still have 60 days to roll over the distribution into a new IRA, both tax- and penalty-free. If you only have a short-term need for the money and can repay the full amount within the 60-day period, the rollover gambit will allow you tax- and penalty-free access to your IRA dollars.
The downside is that the IRS now wants 20% withholding on any distribution thats not a direct rollover into another plan. So, youre only going to get $80,000 in cash and will have to come up with the other $20,000 before the end of the 60-day period. Admittedly, that is expensive money. The IRS also requires that you wait one year before making another rollover from that account. But, the limitation applies to each separate IRA you own. So, this one-year limit wont apply to a different IRA you may own. Annuitize You can avoid the 10% penalty by withdrawing substantially equal annual amounts over your life expectancy until age 59 or for five years, whichever comes later. So, if youre age 58, you must take withdrawals through age 63. But, if youre age 45, you have to continue to make withdrawals through age 59 . Once you finish making the required withdrawals, they can be modified or even stopped. Medical expense and health insurance premiums Here your IRA does become your friend. Your medical expenses are normally deducted as itemized deductions to the extent they exceed 7.5% of your adjusted gross income (AGI). IRA withdrawals are penalty free if used to pay for unreimbursed medical expenses that exceed that figure. So, if you have an AGI of $100,000, you can withdraw, penalty-free, up to your medical expenses in excess of $7,500. If your total medical expenses were $10,000, youd qualify for as much as $2,500 in penalty-free withdrawals. Your withdrawal is sheltered from penalty, up to this amount, even if you dont itemize. Heres where health insurance comes into play. The 10% withdrawal penalty doesnt apply to IRA withdrawals for medical insurance (without regard to the 7.5% AGI reduction) if the following two conditions apply to your situation:
First-time homeowners can use their IRAs Surprise! To qualify for this 10% penalty shelter, you really dont have to be a first-time homeowner. This may really be your fifth home. But, you will qualify if you and your spouse have had no ownership interest in a primary residence for the two-year period ending on the date of acquisition of the new home. Thats when the binding contract to purchase the new residence is signed or when construction begins. Both spouses must qualify. If so, each spouse can withdraw as much as $10,000 without penalty. You can withdraw in chunks less than $10,000. But, this is a maximum $10,000 lifetime exclusion. And, the amount withdrawn must be used within 120 days of the date of withdrawal. The residence may be for you, your spouse, child or grandchild. College expenses Withdrawals for higher-education expenses, such as tuition, room and board, fees, books, supplies and equipment can also be made penalty-free. You can even use the money for graduate-level courses. College expenses qualify if theyre for you, your spouse, your kids or even grandchildren. Death or disability, divorce and job loss If youre disabled or dead, any IRA distributions made to you or to your estate come penalty-free. This is not something you plan on (unless tax and financial planning are very important to you). But, in the appropriate situation, its nice to know youre not going to get killed by the penalty, too. Other penalty exclusions include distributions made to an employee, age 55 or older, after separation from service. Thats fancy tax talk for losing your job. You also escape the penalty if the distribution is made to your spouse under a qualified domestic relations order (QDRO), or if the distribution is made on account of an IRS levy. Death, disability, losing your job, divorce and the IRS. I guess Congress thought those were the worst things that could happen to you and decided to give you a break on the penalty. Inherited IRAs Only a surviving spouse who is a beneficiary of decedents IRA can roll those funds into his or her own IRA. If so, then distributions from the beneficiarys rollover IRA will both escape current taxation and qualify for the above penalty exceptions. Since non-spouse beneficiaries dont have that option, theyre going to be taxed on distributions. But the death exception will shield them from the 10% penalty. Dont forget the income taxes Lets say youve claimed you dont owe the 10% penalty, and the IRS rules otherwise. Can they go after the money? Indeed, they can and probably will. And youll pay interest on the 10% as well. One last point: Weve only discussed alternative ways to avoid the 10% penalty on top of the normal tax. Regardless of what the money is used for, the dollars withdrawn from a traditional IRA are going to be taxed. And, regardless of their source, the distribution is going to be taxed as ordinary income. So try to qualify for one or more of the exceptions. Otherwise, its your money, but youll cry if you take it. | |||||||||||||||
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