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Early Distribution

What is Meant by Half Years of Age?

May 21st, 2012
by jblankenship.
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fireworks

If you’ve paid much attention to the rules around retirement plans (IRAs, 401(k)s, and others), you’ve probably noticed that there are a couple of rules that refer to ages that include “½”.  So what does this mean??

Well, quite literally, this means 6 months after you reach a certain age.  The two primary ages with “½” included are 59½ and 70½.  So, to be age 59½, means that you reached your 59th birthday six months prior to that date.  Likewise, to be age 70½ means that you reached age 70 six months prior to that date.

These two ages are for different purposes and are (naturally) treated differently.

Age 59½

The rule using age 59½ is for one of the exceptions to the penalty for early withdrawals from your IRA or 401(k) plan: once you’ve reached that age (and not before that age) you can take withdrawals from your IRA or 401(k) plan without limits (401(k) plans may also require a separation from service).

Here is an important point: this rule is specifically applied ONCE YOU REACH AGE 59½, and not before.  In the year that you will reach this age, any withdrawals taken from the account before you reach age 59½ will be subject to the 10% penalty if no other exceptions apply.

Age 70½

The rule using age 70½ is regarding Required Minimum Distributions (RMD), as well as limiting contributions to an IRA.  For RMDs, the requirement is simply that you must begin taking the required distributions for the year in which you’ll reach age 70½.  (You can actually delay the first distribution until April 1 of the following year, but the distribution is based on the year when you reach age 70½.)

Note that this is different from the way the 59½ rule works: it’s simply the year in which you’ll reach age 70½, not the specific date that you reach age 70½.  So if your birthday is between January 1 and June 30, your age 70½ year is the year that you reach 70 years of age.  If your birthday is between July 1 and December 31, your age 70½ year is the year that you’ll be reach 71 years of age.

The same holds true for contributions to an IRA: in the year that you’ll reach 70½, you are not allowed to make contributions, and you are not allowed to make contributions thereafter.

You Don’t Have to Count Days

The good news is that you don’t have to count days.  For the purposes of these rules, the half year is the same date, six months later.  For a birthdate of May 11, the half year is reached on November 11 of that same year.  For odd circumstances, such as August 31, of course you’ve reached the half year on February 31 of the following year.  Actually, I believe the rule is that you reach that milestone on March 3 – I’d use this date if you are in this situation, just to be certain.

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When Is a Roth IRA Subject to Income Tax?

Apr 20th, 2012
by jblankenship.
2 comments
Elaine Roth
Elaine Roth (Photo credit: Wikipedia)

Ah, the Roth IRA. That single bastion of non-taxable money in our arsenal of accounts. When you have investments in a Roth IRA, you can take the money out tax-free, right? Not always.

There are several situations where a Roth IRA’s monies can be subjected to tax, penalty, or both.  Listed below are some of those circumstances.

When a Roth IRA is Taxable

It should be noted that contributions to a Roth IRA may always be withdrawn from the account tax-free, for any purpose whatsoever.  There are no restrictions on these withdrawals.

1.  Taking the money out of the account within the first five years of the account’s existence can result in taxation of a portion of the funds.  The portion that is taxable is any withdrawal that exceeds the total of all contributions and conversions into the account.  This rule applies without exceptions.

2.  If your Roth IRA has been in existence for the required five-year time, there are still some qualifications to meet in order to ensure that the withdrawals are completely tax free.  Specifically, you must

  • be at least 59½ years of age; OR
  • you must be disabled; OR
  • you must be taking no more than $10,000 more than the contribution and conversion amount(s) for a first-time home purchase; OR
  • the account owner has died.

If none of those qualifications applies, any amount greater than the conversion/contribution amounts will be subject to ordinary income taxation.

When a Roth IRA is Subject to Penalty

In addition to the specter of taxation, withdrawals from the Roth IRA could also be subject to a 10% early withdrawal penalty (much like a traditional IRA can be).  Here are a couple of cases when the 10% penalty may apply:

1.  Within five years of any conversion into a Roth IRA, if you take out amounts that include the converted funds, the withdrawal of the converted amounts will be subject to the 10% penalty. (unless one of the exceptions applies – see 19 Ways to Withdraw IRA Funds Without Penalty for more details)

2.  Even after the five year period has elapsed, if you are under age 59½ and none of the exceptions from #2 in the “Taxable” section above applies, any amount withdrawn that is greater than the conversions and contributions to the account will also be subject to the 10% penalty.

Wrap up

If the above is a bit confusing, you might need a refresher on the withdrawal sequence – how each dollar of withdrawal from a Roth IRA is attributed, and in what order.  Here’s how it goes:

First, all contributions to the account are withdrawn.  After that, all conversion amounts are withdrawn, starting with the amounts that have been converted for more than five years, and then subsequently any amounts that were converted less than five years ago (and therefore subject to penalty unless an exception applies).

After all conversions and contributions have been withdrawn, any growth in the account is withdrawn.  Growth occurs when the investments in the account gain in value or generate dividends and/or interest.  This money is taken out of the account last – and is the most likely to be both taxable and penalized if taken out before the stipulations above have been met.

For more detail on the withdrawal sequence, see the article Ordering Rules for Roth Distributions.

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The Rollover

Mar 7th, 2012
by jblankenship.
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A Chevrolet Malibu involved in a rollover crash
Image via Wikipedia

You’ve heard it millions of times – on the radio or tv – “when you leave your job, you should roll over your retirement account”. You may know that it makes sense (or at least you assume it makes sense, otherwise why would these folks admonish you to do so?), but do you know why it’s important? And do you have the first clue as to how to accomplish a rollover?

Why rollover? Among the reasons that it is important to rollover your retirement account when you leave employment is that you want to have control over your money. If you leave the account with the former employer, you are effectively handing over a portion of the control of your money to the administrator.

This administrator’s primary job is to ensure that the plan remains as effective and efficient as possible, for your former employer. Your interests are not taken into account at all, and in fact, many activities that the administrator undertakes (and subsequently charges the cost of to the plan accounts) are of no benefit to you whatsoever, as a former employee. By rolling your funds over to a self-directed IRA, you can make sure that the costs associated with your account’s maintenance are directly benefiting your own account.

In addition, by rolling over your retirement funds into an IRA, you now have more flexibility in the investment choices that you can utilize. Remember how your employer’s qualified plan only had five or ten mutual funds to choose from? Now, you can invest in just about any fund, stock, bond, or ETF available in the marketplace, plus some that you can dream up on your own.

How to roll over? We’ve covered (albeit briefly) the “why”, so now we’ll cover the “how”. It’s actually pretty simple, as long as you follow a couple of important rules. Both of these are related to maintaining the tax-deferred nature of your investment.

The first rule is that you should always have an account set up to receive the monies before requesting the withdrawal from your current plan. If you don’t have a place to put the money, the plan administrator will assume that you’re taking a “cash out” distribution, and they’ll withhold 20% tax on the withdrawal. The way to resolve this is to ensure that your withdrawal paperwork (with your old account) indicates a “direct rollover” is occurring. At the same time, your deposit paperwork with your new account will indicate the same. The old plan administrator may still send a check to your home address, but it will be made out to the new account custodian.

The second rule is related to the first, but this is one that you can foul up even if you’ve gotten the paperwork filled out correctly: your rollover must occur within the span of 60 days, or you’ll be penalized as if you withdrew the money to cash out the plan – 10%, plus ordinary income tax on the withdrawal.

As I indicated earlier, the current (old) plan administrator may send you a check for your rollover, made out to the new custodian – but it’s up to you to make sure that you get the check sent to the new plan custodian as soon as possible, so that there’s no danger of taking more than 60 days to complete the roll over.

The entire process is simple enough, following the steps below:

1. establish your new account
2. request a “direct rollover” withdrawal from your old plan
3. receive the rollover check
4. submit the check with the appropriate “direct rollover” deposit slip at your new account.

As you can see, the process is straightforward, but if you don’t pay close attention to what’s going on, or if one of your plan administrators (either the new one or your old one) has a special “twist” to the process, it can become a mess.

Note: steps 3 and 4 are not required if the transfer is done in a trustee-to-trustee manner, meaning that the old account administrator sends the funds directly to the new account trustee, and you never see a check.  This is one of the most common ways to ensure that you don’t miss the 60-day window. For more information, see An IRA Owner’s Manual.

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Facts About the 72t Early Distribution

Feb 1st, 2012
by jblankenship.
1 comment
Ossekeag Creek Marsh
Image by wallygrom via Flickr

In case you don’t know what a 72t distribution is, this is shorthand for the Internal Revenue Code Section 72 part t, and the most popular provision of this code section is known as a Series of Substantially Equal  Periodic Payments – SOSEPP for short.

Enough about the code section already.  What is this thing?  A SOSEPP is a method by which you can access your IRA funds prior to age 59½.  In order to take advantage of this rule, you determine the amount of the annual distribution from your IRA (this is done in a prescribed manner, more on this in a bit) and then begin taking the distributions.  Once you start the SOSEPP, you have to keep it going for the longer of five years or until you reach age 59½.

Methods of Distribution

There are three ways that you can determine the amount of the distribution from your IRA, and all are based upon the balance of the IRA account and your age.  The first method is the simplest, known as the Required Minimum Distribution method.

The Required Minimum Distribution method for calculating your Series of Substantially Equal Periodic Payments (under IRC §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 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. This annual amount will be different each year.

The second method is called 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).

The third method is similar to the second, but it is called 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 one of the two fixed methods, 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.

An Important Note

It’s important to know that the amounts you’ve calculated are and will be the exact figures for your payments from the account, no more, no less.  It’s not allowable to simply name your own amount and take that each year – you have to use the prescribed amount from one of the methods.

The way to impact the amount of the payment is to adjust the balance in the IRA.  If you have more than one IRA available, you can rollover funds into one account and therefore increase or decrease your payment.  This has to be done prior to establishing the SOSEPP though – it’s not allowed to deposit money into or remove funds from your IRA while the SOSEPP is in place (well, other than the required payments from the account each year).

Any deviation from the prescribed payments will cause the SOSEPP to be “busted”, which can result in some not-so-nice consequences – which you can read more about here.  For more about the SOSEPP, see the IRA Owner’s Manual.

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The Post-55 Exception to the 10% Penalty for Withdrawals from 401(k)

Dec 7th, 2011
by jblankenship.
3 comments
55
Image via Wikipedia

Most of the time, when taking a distribution from a 401(k) or other Qualified Retirement Plan (QRP) prior to age 59½, there generally is a 10% penalty that applies.  That is, unless one of the exceptions applies – hardship primarily, although there are others.

If you happen to be over age 55 when you leave employment, there is another exception that applies.  Any distribution that you take from the QRP, as long as you were at least 55 years of age when you left employment, will not be subjected to the 10% penalty, only ordinary income tax.

This provision only applies to QRPs, not to IRAs.  So if you’re leaving employment at or after age 55 but before reaching 59½, it can be in your best interest to not rollover your QRP to an IRA, at least until after you reach 59½.  Even if you don’t need the money right away, it could be beneficial to have the source of funds available penalty-free.

For retiring police, firefighters and medics, the age for this exception is 50 – so these folks can take distributions from their QRPs after age 50 if they’ve left employment without penalty.

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10% Penalty Applied to Roth Conversion? Maybe

Apr 29th, 2011
by jblankenship.
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David Villa taking a penalty kick
Image via Wikipedia

In general, when you withdraw funds from an IRA prior to age 59½, your withdrawal is subject to both income tax and the 10% early withdrawal penalty.  The 10% penalty is waived if your withdrawal is for one of the exception categories, including first-time home purchase, certain medical expenses, and the like.  For a complete list of the exceptions, see the article I had previously written which provides links to the various exceptions to the 10% penalty.

One of the exceptions to the penalty is a withdrawal for a Roth Conversion.  You still must pay tax on the conversion, but generally the 10% penalty will not apply to amounts converted from a traditional IRA to a Roth IRA.

However (and there’s always a however in life), there are a couple of situations where the 10% penalty could impact you as you enact your Roth Conversion.

Funds used to pay the tax

If you used some of the funds from your Roth Conversion to pay the tax on the conversion, then effectively those funds were not converted.  Therefore, if you’re under age 59½, the 10% penalty will apply to those funds that you used to pay the tax on the conversion.

For example, if you converted $50,000 from your traditional IRA to a Roth IRA, and pulled out $5,000 to pay the tax on the conversion, then you really only converted $45,000 into the Roth IRA – and the $5,000 was withdrawn for other purposes – and therefore subject to the 10% penalty.  The entire $50,000 withdrawn from the traditional IRA would also be subject to ordinary income tax.

Funds withdrawn within the first five years

When you convert funds from a traditional IRA to a Roth IRA and you’re under age 59½, the converted funds are restricted from withdrawal for the lesser of five years or until you reach age 59½.  If you withdraw the converted funds from the Roth IRA prior to the date the restriction is lifted, your withdrawal will be subject to the 10% penalty.

This restriction is in place to keep a taxpayer from converting funds to a Roth IRA prior to age 59½ (avoiding the 10% penalty) and then immediately withdrawing the funds from the Roth IRA account, thereby affecting a withdrawal from the traditional IRA without penalty.  By causing a delay for such withdrawals of up to five years, this strategy will lose its luster for someone who is hoping to use it to his advantage.

It does provide a way for an individual to do some advance planning if he or she chose to do so, though…

Advance Planning Strategy

Imagine if you were age 50 and hoped to retire in five years.  You have a traditional IRA, amounting to $250,000, plus a pension and a 401(k) plan at your employer.  You know that you’ll need $50,000 per year to live on during the years of age 55 to 60 – so you could convert $50,000 per year for the next five years, paying the tax from other sources.

Then you would have $50,000 per year available to you, beginning at age 55, that would be totally free from tax and penalty, since the conversion occurred more than five years in the past.  Then, when you reach age 60 you’ll have unencumbered access to your other sources of income (since you’re over age 59½), and in a few years you’ll have Social Security available as well.

It’s not a strategy that will work for everyone, but in certain circumstances it might work well for you.

NOTE: You’d want to plan this out very carefully so that you don’t trip up on any of the conversion dates and your future withdrawal dates.

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More reasons to keep on rolling (to an IRA, that is)

Jun 23rd, 2010
by jblankenship.
3 comments

rolling down a hill by woodleywonderworksWe have discussed in the past that it is usually better to rollover an old 401(k) plan from a former employer to an IRA – more flexibility in investments, (usually) lower costs, more control, etc., are among the chief reasons to do so.

However, in some cases your old 401(k) plan may have access to desirable investments that you couldn’t otherwise access, or possibly you have access to other benefits from participation, such as availability of a financial advisor.  As long as the overall costs remain low in the plan, you might want to leave the funds there.  Plus there are also some additional benefits inherent within 401(k) accounts that are not available to IRAs – you can read up on the reasons to leave your money in the 401(k) in the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k).

On the flip side, there are certain things that you can’t do in a 401(k) (or other Qualified Retirement Plan) that you can ONLY do with an IRA while you’re under age 59½.

IRA-Only Options

With an IRA, there is no penalty for withdrawal for (click the link following each for more detail):

  • Health Insurance Premiums while unemployed – §72(t)(2)(D)
  • Qualified Higher Education Expenses – §72(t)(2)(E)
  • Qualified First-Time Homebuyer Expenses – §72(t)(2)(F)
  • Qualified Reservist Distributions – §72(t)(2)(G)

And none of those are available without penalty from your 401(k).  Of course you would have to pay tax on the distribution, but otherwise you can take the money for those purposes.

In addition, setting up a Series of Substantially Equal Periodic Payments (SOSEPP) is generally easier to qualify for and to set up from an IRA than from a 401(k), so this may be an additional reason to consider rolling over.

Photo by woodleywonderworks

Mistakes With NUA

Apr 3rd, 2010
by jblankenship.
3 comments

In another article on this site we discussed the concept of Net Unrealized Appreciation,  or NUA for short.  It’s a complicated affair, fraught with potential mistakes – several of the most important ones are listed below.

Mistakes With NUA

left by srslyguysMoving too quickly – if you roll over your funds from the Qualified Retirement Plan (QRP) without first checking to see if there can be a benefit from the NUA treatment of company stock in the QRP, you’ve lost the chance to do so.  Always check for NUA possibility within the QRP before making any rollover moves.

Not moving quickly (completely) enough – if you have determined that NUA treatment can benefit your situation, you must move ALL of the funds from the QRP within the same taxable year.  If you moved your NUA stock out first and planned to rollover the rest of the account into an IRA or other employer plan, you must follow through within the tax year – delaying even one day beyond the tax year end will break the NUA option and cause the distributed stock to be fully taxable.

Taking RMDs in an earlier year – if you retired in an earlier year, and began taking Required Minimum Distributions (RMDs), once that tax year ends and you have not taken your Lump Sum Distribution to enact the NUA option, you no longer have the NUA option available to you.  This is due to the fact that the NUA option is available ONLY after a triggering event, and the entire balance must be withdrawn in a single tax year.  If another triggering event were to occur – disability or death – then the NUA treatment could still be available.

Selling out of NUA-potential stock in the QRP – if you have significant holdings of your company’s stock in your QRP, chances are at some point you’ll get nervous about holding too much stock in a single company.  Obviously, you don’t want to overexpose yourself to a volatile stock – but it may not make sense to sell all the stock, either.  If the stock has appreciated over a significant period of time, you might want to maintain a position simply to take advantage of the NUA treatment.

On the other hand, if you’re concerned that the stock is going to drop like a rock, (remember Enron? Worldcomm? CitiGroup? Countrywide?) you should ignore the concept of NUA altogether – you shouldn’t let tax laws wag the financial responsibility dog.  Besides, if the stock drops there wouldn’t be any NUA treatment anyhow.

Not understanding NUA – if you don’t understand it completely, your chances of getting it right are small.  This is a very strict set of rules (aren’t they all though?) and simple moves in the wrong direction can break the option altogether, potentially causing a major tax hit.  It’s also important for your heirs to understand NUA – or make sure that they will work with your NUA-savvy advisor before they make any moves.

Photo by srslyguys

IRA Options for a Surviving Spouse Under Age 59 1/2

Mar 28th, 2010
by jblankenship.
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light my path by faith gobleAs a follow-up to an earlier article on Options For a Spousal Inherited IRA, I wanted to address the specific situation that occurs if you have inherited an IRA from your spouse and you’re under age 59½. There are a couple of choices available to you – which can pose a dilemma.  As we have discussed in other articles, you have the option of leaving the funds in the IRA of your spouse, which will allow you to withdraw from the account at any time without penalty.  There is no 10% penalty for the withdrawal as with most other withdrawals before age 59½.  The downside to leaving these funds in the name of your deceased spouse is that, upon your death, the distribution options are usually unfavorable for that situation.

On the other hand, as a surviving spouse you also have the option of moving the funds from the original account into an account in your own name – which will usually produce better distribution options at your passing, or at least giving you the flexibility to improve the distribution options.  The problem with this move is that once you have moved the funds into your own account, the exception to the 10% penalty for early withdrawal no longer applies.  So, unless one of the other 72(t) exceptions applies you can not access the funds in the new, rollover account until you reach age 59½.

How to Deal With the Dilemma

How should you deal with the dilemma?  It depends completely on your specific situation, but below are some strategies you might consider:

If you’re in dire financial straits without access to the IRA, leave it in your late spouse’s account, at least until you reach age 59½, and then rollover the funds into your own account.  Since there is no deadline for this rollover, you have the flexibility to treat the account in this fashion.  If the event of your untimely death before rolling over the account would produce undesirable distribution requirements, you can address this by purchasing term life insurance with account proceeds, timing the insurance to expire upon your rollover.

If you’re well-to-do (okay, comfortable, or even rich) or in ill health, you should not delay in rolling over the funds into your own account.  This is because when you’ve made this move, you can be in control of the disposition of the account upon your death.  If for some reason you later need to access the funds in the account and you’re still under age 59½, you can either set up a Series of Substantially Equal Periodic Payments (SOSEPP) unless one of the other 72(t) exceptions applies.

What If the Account Requires Lump-Sum Distribution?

If there is a reason to leave the funds in the deceased spouse’s account but the account provisions require that you take a lump sum distribution immediately, you can roll over the account to an Inherited IRA, maintaining the original owner’s name, essentially acting as if you are a non-spouse beneficiary.  This will give you the freedom to begin taking distributions (these are Required Minimum Distributions, RMDs) from the account, without penalty.  Then you can later rollover the funds into your own account at a later date when you no longer need the distributions or you reach age 59½.  This provides you with the option of receiving distributions in smaller amounts and protecting the tax-deferred status as long as possible – in spite of the provision from the original account that required lump-sum distribution.

Photo by faith goble

Eligible Rollover Distributions (ERDs)

Feb 20th, 2010
by jblankenship.
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beethoven by HitchsterSo what funds can be rolled over from your retirement plan into another retirement plan or IRA?  Interestingly, the IRS doesn’t specifically tell you what can be rolled over – but rather, what can not be rolled over.

Let’s look at the definition from the IRS…

Definition

Only Eligible Rollover Distributions, or ERDs, can be rolled over, according to the IRS.  The definition that is given is really an anti-definition, explaining that any normally taxable distribution is eligible for rollover unless it fits the exceptions listed.

An ERD is defined as – a distribution that is eligible to be rolled over to an eligible retirement plan. Eligible rollover distributions include a participant’s balance in a qualified plan, 401(k), 403(b) or 457 plan, except for certain amounts that include the following:

  • Any of a series of substantially equal periodic payments (SOSEPP) paid at least once a year over:
    • The participant’s  lifetime or life expectancy,
    • The joint lives or life expectancies of the participant and his/her beneficiary, or
    • A period of 10 years or more,
  • A required minimum distribution,
  • Hardship distributions,
  • Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains,
  • A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant’s accrued benefits are reduced (offset) to repay the loan
  • Dividends on employer securities, and
  • The cost of life insurance coverage.

So, as long as the distribution plan that you set up doesn’t fit any of the requirements above and has a payout period of 10 years or less, your distributions can be considered ERDs, and therefore rolled over into an IRA or other retirement plan.

Understand that these distributions will be subject to mandatory 20% withholding if paid out to you.  Plus, you must complete the rollover within 60 days when it’s not done by trustee-to-trustee (or direct) rollover.

Whenever possible, you would want to set up these payments as direct rollovers into your IRA (or other QRP) to avoid this withholding requirement and 60-day limit.  If this can’t be done, you should make up the 20% withheld difference from other savings as you rollover the distributions in order to avoid tax and penalties.

Photo by Hitchster
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