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19 Ways to Withdraw IRA Funds Without Penalty

May 2nd, 2009
by jblankenship.
3 comments

10002248We’ve covered a lot of ground on how you can get at your IRA funds in this blog, but here is an all-inclusive list of the ways I’ve come up with to withdraw your funds without triggering the 10% penalty.  This list is for Traditional IRAs only.

It is key to note that, although these exceptions allow the distribution of funds without triggering the 10% penalty, in most cases the account owner would still be liable for the ordinary income tax on distributions.  Consult your tax advisor for additional information.

19 Ways to Withdraw IRA Funds Without Penalty

We’ll start with the obvious:

1. Normal – Begin after age 59½
2.  Before Tax Due – Withdraw annual allowed contributions before the due date of your tax return – an example would be to withdraw your 2008 contributions (and any associated growth) before April 15, 2009.
3.  Excess Contributions – Withdraw excess contributions before the due date of your tax return – if you discovered that you had contributed more than allowed (due to income limits or error) you are allowed to remove the excess and any associated growth before the tax return is due for the year.
4.  Required Minimum Distributions – technically this one is covered by #1 above for most circumstances, but sometimes RMD is required of a person who has inherited an IRA, regardless of age.

Now we’ll move into some of the not-so-obvious methods, starting with SOSEPP.

Series Of Substantially Equal Periodic Payments

This is the classic Section 72(t) method for withdrawing funds without penalty.  Essentially you agree to continue taking the same amount from your IRA for the greater of five years or until you reach age 59½. There are three methods of SOSEPP:

5. Required Minimum Distribution method – uses the IRS RMD table to determine your Equal Payments.
6. Fixed Amortization method – in this method, you calculate your Equal Payment based on one of three life expectancy tables published by the IRS.
7. Fixed Annuitization method – this method uses an annuitization factor published by the IRS to determine your Equal Payments.

Additional Section 72(t) methods for taking distribution from your IRA include:

8. Qualified Higher Education Expenses – you can withdraw your IRA funds to help pay for college
9.  Death – If you die, your beneficiaries are able to take distributions from your IRA without penalty.
10.  Disability – If you are “totally and permanently disabled” by IRS definition, you can take distributions from your IRA without penalty.
11.  High Unreimbursed Medical Expenses – for yourself, your spouse, or your qualified dependent.  If you face these expenses, you are allowed to withdraw a limited amount (the actual expenses minus 7.5% of your AGI) without penalty.
12.  Medical Insurance Premiums – if you’ve lost your job and receive unemployment compensation, you are eligible to withdraw an amount to pay for your medical insurance premiums (with some additional limits).
13.  First-Time Home Purchase – up to $10,000 ($20,000 for a couple) of the costs of buying, building, or re-building a “first home”.  First home is determined if you had no present interest in a main home for two years prior to the purchase.

And lastly, here are a few additional ways that you can withdraw your IRA funds without penalty:

14.  Qualified Reservist – If you were called to duty after September 11, 2001 and serve for at least 6 months, you are allowed to make a withdrawal from your IRA during your active duty period without penalty.
15.  Divorce – although not a particular IRS regulation, multiple Private Letter Rulings have allowed divorced parties to “split” an IRA into two separate IRAs, both with the original restrictions on distribution.
16.  Roth IRA Conversion – when you convert your funds from a Traditional IRA to a Roth IRA, although you pay tax on the distribution, there is no 10% penalty applied.
17.  Rollover – using the 60-day period, you are eligible to have access to your funds without penalty as long as the rollover is completed within 60 days.
18.  Payment to Advisor/Investment Manager – you are allowed to authorize your custodian to pay your Advisor or Investment Manager from your IRA funds any fees for managing your IRA. This includes transaction fees and annual custodian fees.
19. Periodic Temporary “Relief” provisions – from time to time, as the situation merits, Congress will enact special legislation allowing individuals impacted (primarily) by natural disasters to access IRA funds without paying the 10% penalty. One notable example of such a provision was for victims of Hurricane Katrina.

Now, did your list have 25 different ways?  Perhaps I’ve overlooked some… let me know if you have other ways in your list that folks can withdraw IRA funds without penalty. Let me know what you think!

For additional information on most of these methods, see the IRA Owner’s Manual or click the IRA Owner’s Manual link at the top of the page.

Higher Education Expenses Paid From A Qualified Plan

Apr 11th, 2009
by jblankenship.
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Another way to pull funds from an IRA or a qualified retirement plan (401(k), 403(b), 457, etc.) without having to pay the 10% penalty is to use those funds for Qualified Higher Education Expenses (QHEE).  This comes up quite often, as parents are faced with the issues surrounding the dueling requirements of retirement saving and paying for college for the young ‘uns.

We’ve been talking about the components of Internal Revenue Code Section 72, and specifically here we’re talking about §72(t)(2)(E).  In this portion of the code, the provision is made for a taxpayer qualified retirement plan or IRA owner to withdraw, without penalty, amounts “not to exceed the Qualified Higher Education Expenses for the tax year”.

So, you may ask, what is a QHEE? Essentially, this includes tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution.  Also included are expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.

Room and board also qualifies, but only to the extent that it is not greater than the educational institution’s allowance for room and board, or the amount that the institution actually charges for room and board.  In addition, with the passage of the ARRA 2009, computing equipment and services (including internet service) can be included as QHEE, at least for 2009 and 2010 (likely to be extended).

Who is the student? For the purpose of this provision, the student can be the IRA account owner, her spouse, eligible children (generally dependents), and grandchildren.

Amounts withdrawn must be no more than the QHEE for the tax year, reduced by any additional tax benefits applied: 529 or Coverdell ESA account withdrawals; QHEE covered by HOPE or Lifetime Learning credits; or any grants or scholarships received.

Separation From Service On or After Age 55

Apr 6th, 2009
by jblankenship.
2 comments

Did you realize that there is a provision within the Internal Revenue Code that allows you to start taking distributions from your 401(k) plan before you reach age 59½?  This little-known section of the code, §72(t)(2)(A)(v), can be a real dandy if you happen to fit the requirements. 

55-kings-parade-by-dumbledad

Note: although we will refer to the 401(k) throughout this article, this code provision applies to all ERISA-qualified, employer-established defined contribution plans, which includes 401(k), 403(b), 501(a), and others.

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Here’s how it works:  if you are working for a company and are participating in the company’s 401(k) plan, should you decide to leave employment with that company at any time during or after the year in which you reach age 55, there will be no penalty for taking distributions from the plan.  Normally, any distribution (other than specifically-qualified distributions) prior to age 59½ would result in the 10% penalty being applied. 

It is important to note that these distributions only qualify when received from a company-established defined contribution plan – NOT an IRA account.  Just to be clear: THIS PROVISION DOES NOT APPLY TO IRA ACCOUNTS.  In order to maintain this penalty-free distribution, the funds must not be rolled over into an IRA.  This is a critical distinction that you need to understand – a mistake would take away this option completely.  Make certain that you completely understand how this works before starting a distribution, as it could be costly to make a mistake.

Lastly, the Pension Protection Act of 2006 made one additional change to the code:  The age limit is reduced to 50 for retiring police, firefighters, and medics - so they can take distributions from their plans penalty-free at that age or after.

Traditional IRA v. Roth IRA – Compare & Contrast

Apr 4th, 2009
by jblankenship.
4 comments

What’s the difference between the two types of IRAs?  And what is similar?

compare-contrast-by-suvodeb-croppedYou probably know a little bit about this subject – like one IRA is deductible on your income taxes, and the other one has some kind of tax benefit… but the differences are hard to understand, and can be even harder to explain!  Below are the major differences between the two, followed by the similarities.  This discussion is liable to be useful as you consider which kind of IRA is best for you (and both could be best for you, at different times in your life).

Differences Between Traditional IRA and Roth IRA

Deductibility is a feature of the Traditional IRA (TIRA) that is not available in the Roth IRA (RIRA).  What this means is that, subject to the limits we discussed here, you may be able to deduct the amount of your contribution to your TIRA from your Gross Income in the year of the contribution.  When the TIRA was originally introduced in 1974, the deductibility feature was not included.  This was added in 1986, and is one of the primary reasons that TIRAs have remained as popular as they are to this day.  At the time of the introduction of the deductibility feature, very few companies offered 401(k) plans so the TIRA offered one of the only tax shelters available to nearly every taxpayer.

Tax treament is another major difference between the two kinds of IRA.  The TIRA’s distributions are always taxable (if not rollover distributions) as ordinary income, while the RIRA’s distributions are always tax-free (as long as they meet the requirements, such as after age 59½).  What is also very different about the two is that your contributions to a RIRA are always available for withdrawal at any time for any reason – tax free.  The growth in the RIRA (interest, dividends, capital gains) would be taxed and subject to penalty if withdrawn for an ineligible reason, though.  The TIRA does not have such a provision.

Required distributions are the final major difference covered here.  The TIRA has Required Minimum Distributions (RMD) that must begin at the owner’s age 70½, while the RIRA has no requirement for distribution.  In other words, the Roth IRA never needs to be distributed during the IRA owner’s life, while the Traditional IRA must be distributed beginning at the owner’s age 70½.

Similarities Between Traditional IRA and Roth IRA

Income requirement. A component of the requirements of both the TIRA and the RIRA is that the holder (or the holder’s spouse) must have earned income in the year of the contributions.  The income must be at least equal to the total of all IRA contributions for the year.  This includes two additional types of contributions: spousal contributions and non-deductible contributions.

Spousal contributions are allowed for both the TIRA and the RIRA, and they essentially allow a spouse with income to contribute to the IRA (either variety) of the spouse who either does not have income, or whose income is below the maximum available contribution for the tax year.  The contributions are limited, however, to the total of both spouses’ earned income for the tax year.

Earned income, for the purposes of IRA contributions, includes wages, salaries, tips, commissions, self-employment income, or alimony (or separate maintenance payments).  Not included as earned income are earnings and profits from property (rental or royalty), interest income, dividends, pensions, annuities, deferred compensation (such as 401(k) distributions), certain non-participatory partnership income, and capital gains.

Non-deductible contributions to a Traditional IRA are allowable when your MAGI is above the limits (described here).  In essence, if your income is too high to make either a RIRA contribution or a deductible TIRA contribution, you are allowed to make a non-deductible contribution of up to the maximum amount allowable for the year into your TIRA.  These contributions are after tax, and so when distributed there will be tax only on the growth that has occurred in the account.  Non-deductible contributions are a way to defer tax on the growth of funds in an account, and are also available as a spousal contribution.

Tax Year Specification. TIRA and RIRA contributions must be made for a specific tax year.  That is, since there are strict limits on the amounts that can be contributed, you must specify the tax year of the contribution to your IRA.  You are generally allowed to contribute for a tax year beginning on January 1 and ending on the tax due date for the year (generally April 15 of the following year).  In other words, for 2009, you may make your 2009 contribution to your IRA at any time between January 1, 2009 and April 15, 2010.

The same time limit applies to establishing the account as well.  You can even file your tax return early, indicating a contribution to your TIRA (and deducting it from your gross income) before you make the contribution!  Just make sure that you do go ahead and make the contribution… the IRS has very little sense of humor about things like that!

Penalty for withdrawal applies to ineligible distributions from either type of account.  A 10% penalty will be applied to any distribution from an IRA of either variety that is not specifically allowed under §72(t), above and beyond the ordinary tax that would be applied to the distribution.

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Penalties for Changing SOSEPP

Mar 27th, 2009
by jblankenship.
1 comment

broken-bamboo-by-kimberlyfayeSo – you’ve begun your Series of Substantially Equal Periodic Payments (SOSEPP) from your IRA to satisfy your §72(t) requirement.  Allofasudden, something happens that causes you to make a change to your payment – either purposely or by accident.  What happens?

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Well – first of all, we must understand the timeline associated with an SOSEPP:  once begun (notwithstanding the “one-time change” exception which you can read about here), you have to continue those periodic payments without change for the longer of five years or until you reach age 59½.

If you make a change to your periodic payments (other than the one-time change), §72(t)(4) indicates that ALL of your payments, beginning with your first payment under the SOSEPP, will be subject to 1) ordinary income tax (should have already been assessed); 2) the 10% non-qualified withdrawal penalty; and 3) interest on any unpaid tax or penalty, calculated from the date(s) of the disbursal(s) forward to the date you “broke” the SOSEPP.

This is the Code section that should strike the most fear in the hearts of folks who are considering establishing an SOSEPP.  If you think about it, the possibilities for error are numerous – your brokerage fails to execute a disbursement the way you directed; you forget to take your withdrawal; you mistakenly take more (or less) than your SOSEPP prescribes… And if it’s been in place for several years, you’ll owe penalties back to the beginning of the plan, plus interest. 

It doesn’t take much imagination to envision a scenario where you could be in pretty deep with such an error on you plan.  And from what I read, the IRS has very little in terms of a sense of humor when dealing with these cases – not many are overturned. 

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SOSEPP & How a QDRO Affects It

Mar 20th, 2009
by jblankenship.
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In addition to the 72(t) exception available for folks with a QDRO (see this post), there is also the question of how a QDRO impacts an established Series of Substantially Equal Periodic Payments (SOSEPP) – which, as we know, once established can only be changed one time.

separati-en-casa-near-divorce-by-mirko-macariAlthough not definitive, below are summaries of three Private Letter Rulings (PLRs) that seem to suggest first of all that making the distribution is not subject to the 10% penalty when a QDRO or divorce decree is involved, pursuant to the regulation in Code section 72(t)(4)(A)(ii).

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1) The transfer to a taxpayer’s spouse pursuant to a divorce decree of 50% of each of three separate IRAs owned by the taxpayer from which the taxpayer had already begun receiving “substantially equal periodic payments” did not result in a modification where the taxpayer’s spouse was two years younger and would commence receiving similar payments such that the total of periodic payments to the taxpayer and his spouse subsequent to the division would be substantially equal to the periodic payments received by the taxpayer prior to the division. PLR 9739044

2) In PLR 200027060, the IRS rules that a spouse after the divorce, that  received a portion of the client’s IRA accounts that were being used to fund a SEPP,  didn’t need to continue the payments since it was a transfer under Code section 408(d)(6). What about the client – did all the payments have to be continued out of what remained of his accounts?

2a) Later in PLR 200050046 (with similar facts) the IRS ruled in favor of the taxpayer. “The reduction in the annual distribution from IRA 1 to Taxpayer A beginning in calendar year 2001, prior to Taxpayer A’s attaining age 59 1/2 , and assuming Taxpayer A has not died and has not become permanently disabled, will not constitute a subsequent modification in his series of periodic payments, as the term “subsequent modification” is used in Code section 72(t)(4), and will not result in the imposition upon Taxpayer A of the 10 percent additional income tax imposed by Code section 72(t)(1) pursuant to Code section 72(t)(4)(A)(ii).

In other PLRs, it has further been ruled that the IRA owner may reduce the 72(t) payment amount by the same percentage as the reduction in the overall account by distribution to the former spouse.  This is the case for a QDRO granting a division of a qualified plan or a divorce decree granting a division of an IRA when the SOSEPP has already been set up.  In these cases, the former spouse who receives the proceeds from the IRA or qualified plan was not required to continue a 72(t) payment plan – the funds could be rolled over into an IRA, or left in the plan as is.

It is also important to note that the RMD (Required Minimum Distribution) for the year of the transfer is still dependent upon the previous end-of-year balance in the account – and could be adjusted for the following year if a favorable PLR is reached for the case.

401(k) & Qualified Domestic Relations Orders (QDRO)

Mar 19th, 2009
by jblankenship.
4 comments

An exception to the 10% penalty on distributions from a qualified plan (but not an IRA) is when the distribution is pursuant to the imposition of a Qualified Domestic Relations Order, or QDRO (cue-DRO).

love-lasts-by-foundphotoslj1A QDRO is often put into place as part of a divorce settlement, especially when one spouse has a considerably larger retirement plan balance than the other.  What happens in this case is that the court determines what amount (usually a percentage, although it could be a specific dollar amount) of retirement plan’s balance is to be presented to the non-owning spouse.  Once that amount is determined and finalized by the court, a QDRO is drafted and provided to the non-owning spouse, which allows the non-owning spouse to direct the retirement plan custodian to distribute the funds in the amount specified. 

In the case of a QDRO, the owning spouse will not be taxed or penalized on the distribution.  In addition, if the non-owning spouse chooses to roll the distribution into an IRA, there would be no tax or penalty on the distribution to her, either.  If the non-owning spouse chooses to use the funds in any fashion other than rolling over into another qualified plan or IRA, there will be tax on the distribution, but no penalty.

Many times it may make sense for the non-owning spouse to leave the account with the qualified plan (rather than rolling into an IRA) if there may be a need for the funds at some point in the future.  This will be dependent upon just how “divorce friendly” the qualified plan custodian will be.

Of course other 72(t) exceptions could apply, but if there was a need that did not fit the exceptions and the distributee did not wish to establish a series of substantially equal payments for five years, the QDRO would still apply to the distribution from the qualified plan (as long as the funds are still in the plan that the QDRO was written to apply to).

As an example, let’s say Lester and Edwina (both age 40) are divorcing, and as a part of the divorce settlement, Edwina’s 401(k) plan is to be shared with Lester, 50/50, with a QDRO enforcing the split.  After a couple of years Lester decides he would like to use some of the funds awarded to him from the divorce to purchase a new fishing boat.  As long as the funds are still held in Edwina’s 401(k) plan, Lester can request withdrawal and receive the funds without penalty, due to the existence of the QDRO.  However, had Lester rolled over the funds into an IRA (or other qualified plan), the QDRO would no longer be in effect, and he would be unable to access the funds without paying the penalty for early withdrawal.  (It is important to note that, in either case, Lester would be required to pay ordinary income tax on the distribution.)

SOSEPP – Fixed Annuitization method

Nov 6th, 2008
by jblankenship.
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When calculating your Series of Substantially Equal Periodic Payments (SOSEPP), provided for under §72(t)(2)(A)(iv) of the Internal Revenue Code, one of your choices is the Fixed Annuitization method.

Calculating your annual payment under this method requires you to have the balance of your IRA account and an annuity factor, which is found in Appendix B of Rev. Ruling 2002-62 using the age you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under the Fixed Annuitization method, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

SOSEPP – Fixed Amortization Method

Nov 6th, 2008
by jblankenship.
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When calculating your Series of Substantially Equal Periodic Payments (SOSEPP), provided for under §72(t)(2)(A)(iv) of the Internal Revenue Code, one of your choices is the Fixed Amortization method.

Calculating your annual payment under this method requires you to have the balance of your IRA account, from which you then create an amortization schedule over a specified number of years equal to your life expectancy factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year, coupled with a rate of interest of your choice that is not more than 120% of the federal mid-term rate published by regularly the IRS in an Internal Revenue Bulletin (IRB).

Once you’ve calculated your annual payment under the Fixed Amortization method, your future payments will be exactly the same until the SOSEPP is no longer in effect. There is a one-time opportunity to change to the Required Minimum Distribution method, described here.

SOSEPP – RMD Method

Nov 6th, 2008
by jblankenship.
2 comments

The Required Minimum Distribution method for calculating your Series of Substantially Equal Periodic Payments (under §72(t)(2)(A)(iv)) calculates the specific amount that you must withdraw from your IRA (or other retirement plan) each year, based upon your account balance at the end of the previous year, divided by the life expectency factor from either the Single Life Expectancy table, the Uniform Lifetime table, or the Joint Life and Last Survivor Expectancy table, using the age(s) you have reached (or will reach) for that year. This annual amount will be different each year.

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