Structuring IRA Distributions To Avoid Penalties - Protected Harbor Planning: A Few Helpful Techniques
by Chris on February 15, 2010
IRA distribution rules are a mine field. One incorrect move and you could discover yourself faced with high taxes and penalties which could wipe out years of savings and investment. Complicating matters 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 laws was enacted to severely punish those who don't follow the policy, to the letter of the law. IRAs come in various flavors but, for purposes of this article we will focus on the 2 chief forms 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 as an early distribution and is matter of a 10 percent penalty on the taxable amount received in a distribution. There're particular IRA distribution rules that can be used to avoid the burden of this early withdrawal penalty.
1. Using IRA Money to Purchase or Build Your First Home - As much as $10,000 may be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to purchase, construct or rebuild a first house for yourself, your wife, you or your spouse's child, you or your spouse's grandchild or you or your wife's parent or ancestor.
2. Using IRA Money for Medicinal Bills - Penalty-free early distributions can be made if the money are used to pay unreimbursed medical costs which exceed 7.5 percent of your adjusted total earnings. There is no requirement to itemize deductions to qualify for this exception.
3. Using IRA Funds for College Expenses - Traditional IRAs can also be tapped to help fund school costs; however, the taxable amount of the distributions from these IRAs will be matter of income tax in the year of the distribution.
Roth IRA distribution rules
Roth IRAs have unique policy with respect to distributions. Contributions withdrawn aren't matter of the ten percent penalty and there is no RMD with Roth IRAs.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 should have been opened for five years and the distributions must be made after reaching age 59 1/2. If you meet the five-year rule but not the 59 1/2 year regulation, distributions in excess of your contributions will be taxable and subject to a ten percent penalty.
1. No RMD - With Roth IRAs, there's no RMD at age 70 1/2. This means a Roth IRA operator is never required to make a distribution out of their Roth IRA. As a result, 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 are not matter of income tax...ever. This means you're unaffected by future tax increases as your effective tax rate is always the same...zero.
3. Conversion Chances - Beginning after January 1, 2010 anybody, irrespective of their income 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. University Expenses - Because Roth IRA contributions might be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child's college expenses.