Avoid Penalties on Your IRA

Last week, I wrote about investing ‘into’ an IRA. One of our California clients called with questions about taking money ‘out of’ an IRA early.  This question is a good one because most people aren’t sure what the rules are.  I will explain them—one at a time–because the rules are slightly different for a Traditional IRA and a Roth IRA.

Traditional IRA. Normally, if you make a withdrawal from your Traditional IRA before age 59 ½, you are subject to a Federal penalty of 10% plus you must report the withdrawal as ordinary income.  This ‘double-whammy’ is such a bad deal that it should be avoided in all but the most extreme situations. You can avoid the penalty under the following circumstances:

• First-time Homebuyer.  Up to $10,000 may be withdrawn by first-time homebuyers.  The money can be used for your principal residence, your spouse’s principal residence or the principal residence of your or your spouse’s children or grandchildren.  You may not realize that a residence is treated as a principal residence if you, and/or your spouse if married, have not owned a principal residence for two years.  The $10,000 is your lifetime limit.  However, if you are married, your spouse also has a $10,000 limit but he or she must also meet the first-time homebuyer tests.
• Education Expenses.  Funds withdrawn for post-secondary education expenses for you, your spouse or the children or grandchildren of you or your spouse are not subject to the penalty.  Expenses that qualify include tuition and fees, books, supplies, and required equipment.
• Medical Insurance Premiums.   I hope you avoid this one because it means you are out of work. To qualify for this exception, you must have received federal or state unemployment benefits for a minimum of 12 consecutive weeks.  Self-employed persons qualify if they would qualify for unemployment compensation except that they are self-employed.
• Substantially Equal Distributions.  This is a nifty little exception in the law that says you avoid the penalty for early withdrawal by taking the IRA funds out in substantially equal payments according to a schedule provided by the IRS and based on your life expectancy.  Once you start these payments, you must continue them for the later of 5 years or age 59 ½.

It’s important to note that while these exceptions allow you to avoid the federal penalty on early withdrawals, you will still have to include the withdrawals as income for income tax purposes.

Roth IRA.  Withdrawals from a Roth IRA are subject to some of the same rules as the Traditional IRA but there are differences as well.  To qualify for an exception to the 10% federal penalty, you cannot make any withdrawals for a minimum of five years from the date of funding your account.  The little known fact is that date of first deposit into your Roth account is the date you must be concerned with.  Future deposits do not start a new 5-year clock running.  In addition, many people don’t realize that this 5-year rule applies even if you are over age 59 ½.  Also, don’t forget that qualified withdrawals from a Roth IRA are not subject to income taxes.  Here are the exceptions:

• Disability.  If you are disabled, you can make withdrawals free of penalties.
• Death.  At your death, your beneficiary can take withdrawals penalty and income tax free.
• First-time Homebuyer, Educational expenses and Medical Insurance Premiums.  These exceptions, known as the ’72(t) exceptions’ are the same as for the Traditional IRA.

The real power of the Traditional IRA and Roth IRA is in allowing your money to grow in a tax deferred manner for as long as possible.  Do your best to avoid taking early withdrawals, but if you must, be sure to follow the rules in order to avoid the federal penalty.