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Ed Slott's Free IRA Update
May 2009
Volume 2, Number 5
In This Issue
·         Focus on – Early Distribution Penalties
·         Question of the Month
·         News, Rulings and Other Updates
·         Retirement Planning Tip
·         Ed Slott’s IRA Advisor – May Issue
 
 
 Resources
 
 
Expert
Professional
Assistance
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
May Focus: Early Distribution Penalties
 
An increasing number of individuals are making withdrawals from funds that were earmarked for retirement. For many, a potential consequence of making withdrawals before retirement could mean working much longer than originally planned. For those who are under the age of 59 ½, they could owe the IRS an early distribution penalty of 10% in addition to being required to pay income tax on withdrawals of pre-tax amounts.
 
 
The Early Distribution Penalty
 
The early distribution penalty applies to any distribution that occurs from a qualified plan, 403(b) or IRA before the owner reaches age 59 ½ , unless an exception applies. Some of the exceptions apply only to IRAs, some apply to qualified plans and 403(b)s, and the rest apply to both categories of accounts. Taxpayers who do not qualify for an exception may suffer “sticker shock” on discovering the penalty owed when it comes time to file their tax return and remit payments to the IRS. For instance, a distribution of $10,000 may not only result in income tax being owed on the amount, but could also be subject to an early distribution penalty of $1,000 ($10,000 x 10%).
 
The Exceptions
 
The exceptions to the 10% early distribution penalty include the following:
 
Exception
IRAs Only
Qualified plans 403(b)
Both
Distributions from inherited retirement accounts 
 
 
X
Distributions from nontaxable amounts
 
 
X
Distributions due to IRS levy on the retirement account
 
 
X
Eligible rollover distributions that are rolled over within 60-days
 
 
X
Qualified reservist distributions
 
 
X
Unreimbursed medical expenses that are more than 7.5% of adjusted gross income
 
 
X
Substantially equal periodic payments (SEPP)
 
 
X
Roth IRA conversion amounts
 
 
X
Distributions while the taxpayer is disabled
 
 
X
First time home buyer distribution
X
 
 
Distributions are not more than the taxpayers qualified higher education expenses
X
 
 
Distributions are not more than the cost of the taxpayer’s medical insurance, if certain conditions are met
X
 
 
Distribution is made payable to an alternate payee under a qualified domestic relations order (QDRO)
 
X
 
Distribution made after separation  from service in or after the year participant reaches age 55 (age 50 for qualified public safety employees)
 
X
 
Distribution is made from an employee stock ownership plan for dividends on employer securities held by the plan (QRPs only)
 
X
 
 
 
Notes:
  • Distributions from governmental 457(b) plans are not subject to the early distribution penalty, unless the distribution represents amounts that were rolled over from a qualified plan, 403(b) or IRA.
  • Distributions from Roth IRAs are not subject to the early distribution penalty, unless the distribution is nonqualified and taken from conversions that have not been in the Roth IRA for at least five years, or from earnings.
 
Reporting the Penalty
 
If a distribution qualifies for the exception to the penalty, the payer is required to make that indication on IRS Form 1099-R, but only in cases where they are certain that the exception applies. For instance, the payer is not required to indicate that the exception applies if the taxpayer indicates that the distribution will be used to purchase a first time home.  In cases where they are required to indicate that the exception applies, the indication is made in Box 7 of Form 1099-R, and includes the following:
 
  • Code 2 for IRS Levy, Direct Roth Conversion
  • Code 3 for disability
  • Code 4 for death, and
  • Code G for direct rollovers
 
If the payer is unsure if the amount qualifies for an exception, Code 1 is inputted in Box 7. Code 1 means that no exception applies to the distribution. In such cases, if the taxpayer qualifies for an exception, he should file IRS Form 5329 and complete the required sections so as to notify the IRS of the exception. Form 5329 should also be filed if the payer indicates that an exception applies, when one does not.
 
Payer Does not Withhold Penalty
 
While the payer will withhold federal and state tax if required to do so, they will not withhold the early distribution penalty. Instead, the taxpayer must pay the penalty directly to the IRS by including the amount in the “Other Taxes” section of his tax return.
 
Conclusion
Taxpayers who make withdrawals from their retirement accounts before retirement often do so because of financial hardships. Because these withdrawals normally result in the payment of income taxes, state taxes and in some cases an early distribution penalty, a taxpayer might tend to make a larger withdrawal from his account. The net result of this action is that while he will have enough money to cover his financial need and to satisfy the taxes and penalties, he will have a substantially smaller retirement account balance.
 
 
Explanations of the rules that govern IRAs are usually provided in Ed Slott’s IRA Advisor Newsletter. If you are not already a subscriber and want to get an idea of the content of the newsletter, you can preview past issues before subscribing.
 
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Question of the Month
Question: I made a contribution to my Roth IRA during 2007. However, I later found out that I was ineligible for the contribution because the only income I received for the year was rental income. I missed the deadline for removing the contribution. What are my options for correcting the ineligible contribution?
  
Answer: Since you missed the deadline for removing the amount as a return-of-excess contribution, you owe the IRS a penalty of 6% of the amount for 2007. This penalty is reported on IRS Form 5329. Under the Roth IRA rules, the amount is automatically designated as a contribution for the following year, which means that it is now a 2008 Roth IRA contribution. If you do not have eligible income/compensation for 2008, you will owe the IRS another 6% penalty and that will continue for each year the amount remains in your Roth IRA, unless you are eligible to make the contribution. The excess contribution can still be withdrawn by December 31, 2009, in order to avoid the 6% penalty for 2009. Generally, you must withdraw the entire amount of the contribution as an excess contribution before year end. Net income or loss is not included when you withdraw the excess contribution after the deadline.
 

News, Rulings and Other Updates
Representative John Boehner (R-Ohio), has introduced The Savings Recovery Act (H.R. 2121), which is co-sponsored by several of his colleagues. The bill includes the following provisions:
 
  • To eliminate the income limitations and marriage penalties that apply to retirement accounts, such as those that apply to the deductibility of IRA contributions
  • To increase contribution limits for retirement plans
  • To extend the RMD waiver until 2012
  • To allow the savers credit for 529 plans
  • To allow investment changes to be made twice per year for 529 plans
 
We will let you know if the bill becomes law.
 

May’s Retirement Planning Tip:  Re-Evaluate Your Retirement Calculator
 
The AARP recently published a study which highlighted the shortcomings of many retirement calculators. According to the study, many calculators fail to take healthcare needs into consideration. The fact is that most of the calculators also fail to take into consideration other areas including the individual’s total assets as well as other sources of income and expenses. An efficient, effective and realistic retirement planning tool would not only let the individual know if he is financially ready for retirement, but also provide workable and realistic solutions for those who are not.
 
If your calculator only asks for your income, accumulated savings, projected rate of return on investments, current and projected tax rates, and your anticipated retirement age, then that is all it is - a calculator - and thus may not be an effective retirement planning tool. As such, you should continue looking for good retirement planning software. When comparing different versions of software, look for the ones which consider the broadest range of factors that could affect your financial status.
 
 

Highlights from Ed Slott’s IRA Advisor Newsletter - May 2009 Issue
 
The May 2009 issue of Ed Slott's IRA Advisor is now available online. 
 
When a client says "I need money to live on" where should that money come from? That's the focus of our feature article "Advising Clients Who Need Money Now."
 
Also in this issue - a unique Roth IRA conversion strategy - having your clients pay for their parents' Roth conversions. Lots of big, long-term benefits, and some pitfalls.
 
WHAT'S INSIDE?
 
Feature Article
Advising Clients Who Need Money Now
  • Available Cash
  • Capital Gain Income
  • Ordinary Income
  • Minimize Penalties
- Age 55 Exception
            - Net Unrealized Appreciation (NUA)
  • When IRARollovers are a Better Option
  • Problem Withdrawals
            - 72(t) Payments (SOSEPPs)
            - Taking Plan Loans
  • Age 59 ½ to Age 70 ½
  • Accessing IRA Funds After 70 ½
  • Tax-Free Money
  • Advisor Action Plan
 
Guest IRA Expert
Martin James, CPA/PFS      
Mooresville, Indiana
 
Roth Conversion Strategy - Helping Clients by Helping Their Parents


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