Structuring IRA Distributions To Avoid Penalties - Protected Harbor Planning: A Few Helpful Techniques
by Chris on February 15, 2010
IRA distribution rules are a mine field. One incorrect move and you could find yourself faced with high taxes and penalties that may wipe out years of savings and investment. Complicating issues is the Darwinian evolution of IRAs that have taken place since the pioneer IRA was launched in '74 with the enactment of the Employee Retirement Income Security Act (ERISA ). Since '74, IRA regulations have changed dramatically and legislation was enacted to rigorously punish those who do not follow the policy, to the letter of the regulation. IRAs come in several flavors but, for purposes of this article we'll focus on the 2 main kinds of IRAs: Traditional IRAs and Roth IRAs.
Methods for Minimizing Penalties on Early Distributions
Generally, any distribution from an IRA before you reach age 59 1/2 is considered as an early distribution and is matter of a 10 percent penalty on the taxable amount received in a distribution. There're certain IRA distribution rules that can be used to avoid the imposition of this early withdrawal penalty.
1. Using IRA Funds to Buy or Construct Your First House - As much as $10,000 may be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to purchase, build or repair a first house for yourself, your spouse, you or your spouse's kid, you or your spouse's grandchild or you or your wife's parent or ancestor.
2. Using IRA Funds for Medical Costs - Penalty-free early distributions could be made if the funds are used to pay unreimbursed medical costs which exceed 7.5 percent of your adjusted total earnings. There's no obligation to itemize deductions to be eligible for this exception.
3. Using IRA Money for School Expenses - Traditional IRAs can be also tapped to aid fund university costs; however, the taxable amount of the distributions from these IRAs shall be matter of income tax in the year of the distribution.
Roth IRA distribution rules
Roth IRAs have unique rules with respect to distributions. Contributions withdrawn are not matter of the ten percent penalty and there's no RMD with Roth IRAs. So as for Roth IRA earnings distributions to be tax-free, the account should have been opened for five years and the distributions should be made after reaching age 59 1/2. If you fullfil the five-year rule but not the 59 1/2 year rule, distributions in excess of your contributions might be taxable and subject to a 10% penalty.
1. No RMD - With Roth IRAs, there's no RMD at age 70 1/2. This means a Roth IRA operator is never required to make a distribution out of their Roth IRA. Because of this, Roth IRAs can grow, untaxed, throughout the lifetime of the owner, permitting a larger legacy for their beneficiaries.
2. Zero Percent Effective Tax Rate - Qualified distributions from Roth IRAs aren't subject to income tax...ever. This means you're unaffected by future tax increases as your effective tax rate is constantly the same...zero.
3. Conversion Possibilities - Beginning after January 1, 2010 anyone, irrespective of their earnings level, may convert conventional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be deferred into 2011 and 2012. If you do not have sufficient money set aside to do a 100% conversion you can do partial conversions.
4. College Expenses - As Roth IRA contributions might be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child's university expenses.
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