Avoid IRA Early Withdrawal Penalties

Published: 16th February 2010
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Early Retirement Steps

You can take out money fee-free in some circumstances.

Early retirement is a prime goal for many people. If you get your gold watch while in your 40s or 50s, you might have to tap your IRA for living expenses. But there is a 10% penalty on withdrawals before age 59 1/2. That's on top of income tax you pay on withdrawals.

Say you take $50,000 from your IRA at age 52. You'll owe $14,000 in tax if you're in a 28% bracket. And you'd owe a $5,000 penalty: 10% of your $50,000 withdrawal.

You can't avoid the tax. But there are ways to avoid the 10% penalty:

Your death. If a loved one inherits your IRA, he or she can withdraw money without a 10% penalty. Age won't matter.

Disability. An exception to the penalty applies if you can't work because of a mental or phyisical condition. You must furnish proof, such as a doctor's letter, that your disability is long and indefinite.

Medical expenses. The 10% penalty won't apply to the amount spent on unreimbursed medical expenses over 7.5% of your adjusted gross income. Say your AGI is $150,000 this year and your net medical costs are $25,000. The threshold is $11,250: 7.5% of $150,000. IRA withdrawals over that have no penalty. so you could take up to $13,750 from your IRA, penalty-free.

Medical insurance. If you have lost your job and received unemployment insurance for 12 straight weeks, you can take money from an IRA to keep your health insurance in force. No penalty will be due.

First-home purchase. You can take penalty-free withdrawals up to$10,000 to buy or build a "first home." To qualify, you cannot have owned a residence during the previous two years.

Higher education costs. The amount you pay for post-high school education also enjoys an exemption from the 10% penalty. Eligible expenses include tuition, room and board, fees, books, supplies and required euipment. The expenses don't have to be for your own schooling. Qualifying expenses can be yours, your spouse's, your children's, even your grandchildren. Say you retire at 52 with two kids in college. The total college expenses this year are $60,000. You can withdraw up to $60,000 from your IRA, penalty-free.

Annuity distributions. To qualify, you must take a series of substantially equal payments. These payments are calculated to match your life expectancy when you start taking them. Or you can use a joint life expectancy with a beneficiary. Plans adopted after 2002 must use an annuity table published by the IRS. A plan already adopted before 2003 can use any mortality table the IRS views as reasonable. Say your life expectancy is 30 years on IRS tables. You'd start by taking 1/30 of your IRA. But the calculation may not be that simple. The IRS approves three distribution methods. Each is calculated differently. One method lets you take out a minimum amount. This leaves more in your IRA to grow tax-deferred. The other two methods are more complicated. They will allow you to withdraw more spending money sooner, penalty-free. The calculations weigh such factors as growth rate of your account. They also look at how much your annual earnings are offset by withdrawals and how your life expectancy shrinks yearly. You may prefer to let your fund company, bank or tax preparer help with the calculations. The financial firm holding your IRA can do the math. Then you can choose the method that best suits your goals. If you have several IRAs at multiple firms, you might have to hire a tax pro to make the calculation. You can take the distributions from one IRA while leaving the others intact. Once you start payouts, you must continue for at least five years. and you must take at least one distribution each year until you reach age 59 1/2. Say you start these annuity payments at age 57. You must keep them up until age 62. Then you can stop. Or you can do in the other direction. You can take out more. You'll have flexibility because you'll be beyond the penalty age.

Retro penalties

But suppose you start at age 52. You will be only 57 after five years. So you must keep going until 59 1/2. What if you stop these payments too early? Or you take out more or less than the permitted amount?

Generally, you'll owe retroactive penalties, plus interest.

Say you start at age 52, taking $25,000 a year from your IRA. Then at age 54 you go back to work so you no longer need the withdrawals.

If you stop the payments after taking a total of $50,000 from your IRA, you's owe a $5,000 penalty and interest on the $5,000 shortfall.$

Ray Buckner (Chicago, Illinois) provides personal financial planning and wealth management services for professionals in the greater Chicago metropolitan area. His primary focus is serving pre-retirees who are preparing for a successful retirement as well as those who have already retired and want to develop a 100% retirement income personal paycheck. His pre-retiree clients want to focus on replacing 100% of their last year's income and keep their current standard of living through out their retirement adjusted each year for inflation.


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