September Focus - Premature Distributions from IRAs The current economic conditions have left many individuals feeling like they have no choice but to tap into their retirement savings in order to make ends meet. For some, the dilemma is deciding between withdrawing from retirement savings or taking consumer loans. Making withdrawals from retirement accounts may seem like the better option as there are no repayments due; but the negative impact of making early distributions can be far reaching, especially for individuals who are under the age of 59 ½ when the distribution occurs. In this article we will focus on early distributions from IRAs-including Roth IRAs, and the possible financial impact of those distributions. Except for amounts attributable to nondeductible contributions, rollovers of after-tax amounts and Roth IRA conversions and contributions, distributions from IRAs that are not rolled over are taxable and will increase the IRA owner's taxable income for the year that the amount is withdrawn from the IRA. For those who are close to the top of their tax bracket, the distribution could push them into a higher tax bracket and increase the income tax that they would pay on some of their other income received during the year. As a result, the net effect of the distribution could be less than anticipated, as a portion of the distribution would be lost to higher income taxes. Early Distribution Penalty If the distribution occurs before the IRA owner reaches age 59 ½, a 10% early-distribution penalty will be owed to the IRS on any taxable amount of the distribution, unless the IRA owner qualifies for an exception to the penalty. These exceptions include the following: - The distribution is not more than the cost of the IRA owner's medical insurance, if the medical insurance is for the IRA owner, his spouse, or his dependents if all of the following conditions apply: - He received unemployment compensation paid under any federal or state law for 12 consecutive weeks because he lost his job. - He receives the IRA distributions during either the year he received the unemployment compensation or the following year. - He receives the distributions no later than 60 days after he has been reemployed. - The IRA owner has unreimbursed medical expenses that are more than 7.5% of his adjusted gross income. The IRA owner does not have to use itemized deductions to get this exception.
- The IRA owner is disabled.
- The IRA owner is the beneficiary of a deceased IRA owner, and the distribution is taken from an inherited/beneficiary IRA.
- The distributions are being taken under a substantially equal periodic payment (SEPP or 72(t)) program.
- The distributions are not more than the IRA owner's qualified higher education expenses.
- The distribution is used to buy, build, or rebuild a first home.
- The distribution is due to an IRS levy on the IRA.
- The distribution is a qualified reservist distribution.
The 10% early distribution penalty can seem like a non-issue, until tax time, when it must be paid. Consider that a distribution of $20,000 would mean a penalty of $2,000. Loss of Tax-Deferred Growth Withdrawing any amount from the IRA before retirement means that the amount will no longer benefit from compounded tax-deferred growth, where earnings accrue upon earnings because the taxes on those earnings are not paid until the amount is withdrawn from the IRA. In the case of Roth IRAs, the loss is even more severe as those earnings would eventually be tax-free. Before taking an early distribution from an IRA, the IRA owner should weigh the pros and cons. These include giving consideration to whether any income tax, early-distribution penalty or the loss of tax-deferred growth outweigh the benefits received from the use of the amount withdrawn. In some cases, it may make better financial sense to withdraw the amount. For instance, if the individual needs to pay off high interest credit card debts, the benefits of paying off those credit card balances may outweigh the benefits of leaving the funds in the IRA. In order to make a proper determination, an analysis should be done to compare the net financial impact of each choice. Careful consideration must be given to the impact a withdrawal can have on the IRA owner's tax and financial profile. Where possible and permissible, the amount can be rolled back to an IRA within 60-days of receipt, resulting in the distribution being restored to the IRA and excluded from the individual's income. In instances where the funds are needed on a short term basis, the individual should consider taking a loan from other sources - including family members - as the cost of those loans may be far less than the cost of raiding the IRA. Detailed information on distributions from IRAs is available in IRS Publication 590, available at www.irs.gov.
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Question of the Month
Question: An individual just graduated from college and received a gift of $5,000 from his grandmother. He will start working next month, but he wanted to fund a Roth IRA now. Can he make his Roth IRA contribution from the $5,000 even though he has not received any compensation as yet?
Answer: Yes. The funds used to make IRA contributions can come from any legitimate source. Therefore, as long as he receives eligible compensation for the year that is at least the amount of his IRA contribution, the contribution can remain in the IRA. If his compensation is less than his IRA contribution amount, then he needs to remove the excess amount by October 15 of next year.
News, Rulings and Other Updates
¨ The IRS has issued a '401(k) Fix It Guide' to help employers determine if their 401(k) plans are involved in any mistakes. The guide includes a list of mistakes that can be made, the process for correcting the mistakes, and the steps that can be taken to avoid these mistakes. The guide is available at www.irs.gov. This is especially important for small business owners who maintain a 401(k) plan and serve as their own plan administrators but do not have the expert knowledge and experience to administer the plan, as these mistakes can result in plan disqualification. For more on the possible effects of 401(k) mistakes, see the September 2008 issue of Ed Slott's IRA Advisor Newsletter. ¨ The IRS has issued final regulations on converting a non-Roth IRA annuity to a Roth IRA. The regulations provide guidance on the tax consequences of the conversion and address the determination of fair market value of the conversion. These regulations apply to Roth IRA conversions where an annuity contract is distributed or treated as distributed from a traditional IRA on or after August 19, 2005. The regulations are available at http://www.federalregister.gov/OFRUpload/OFRData/2008-17271_PI.pdf
September Retirement Planning Tip
Retirement account owners and beneficiaries who are required to take required minimum distribution (RMD) amounts from their retirement accounts by December 31 should consider taking steps now to ensure the distributions are processed on time. Failure to meet the December 31 deadline could result in the individual owing the IRS an excess accumulation penalty of 50 percent of the RMD amount that is not withdrawn by the deadline. Financial institutions are usually bombarded with RMD and other year-end related requests during the last few months of the year, often resulting in processing errors and some requests being overlooked. Submitting requests early allows for time to review statements to determine if the request was processed, and if so - whether it was processed for the correct amount.
Highlights from Ed Slott's IRA Advisor Newsletter - September 2008 Issue
The September 2008 issue of Ed Slott's IRA Advisor is now available online. The areas covered include the following: - Make Sure Qualified Plans Stay That Way... or Else o Employer Eligibility Failures - The Results of Disqualification - Corrections Under the Employee Plans Compliance Resolution System ("EPCRS") - Reference Chart: 2008 Limitations when Individuals Own or Participate in Multiple Retirement Plans. This chart shows you the maximum amount that can be contributed in 2008 to all types of company plans and IRAs, specifically when a client is active both as an employee of a company and as a self-employed business owner. Denise Appleby, APA, CISP, CRC, CRPS, CRSP Be sure to review the September issue and post your questions on our message board at http://www.irahelp.com/phpBB/index.php?area=, where some of the best experts in the retirement field gather to discuss technical issues.
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