Structuring IRA Distributions To Prevent Penalties - Safe Harbor Planning: Several Effective Techniques
IRA distribution rules are a mine field. One incorrect move and you could discover yourself faced with high taxes and penalties that may wipe out years of savings and investment. Complicating issues is the Darwinian evolution of IRAs which have taken place since the first IRA was launched in 1974 with the enactment of the Worker Retirement Income Security Act (ERISA ). Since '74, IRA regulations have altered dramatically and legislation was enacted to severely punish those who don't follow the policy, to the letter of the rule. IRAs come in a lot of flavors but, for reasons of this article we will focus on the two major kinds of IRAs: Traditional IRAs and Roth IRAs.
Approaches for Minimizing Penalties on Early Distributions
Generally, any distribution from an IRA before you reach age 59 1/2 is considered an early distribution and is subject to a 10 percent penalty on the taxable amount received in a distribution. There are particular IRA distribution rules that can be used to avoid the imposition of this early withdrawal penalty.
1. Using IRA Money to Buy or Build Your First Home - Up to $10,000 may be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to buy, build or reconstruct a first home for yourself, your wife, you or your spouse's kid, you or your spouse's grandchild or you or your wife's parent or ancestor.
2. Using IRA Money for Medical Costs - Penalty-free early distributions could be made if the funds are used to pay unreimbursed medicinal expenses which exceed 7.5 % of your adjusted gross income. There's no condition to itemize deductions to qualify for this exception.
3. Using IRA Money for College Costs - Traditional IRAs can also be tapped to aid fund school expenses; 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 Contributions withdrawn aren't subject to the 10% penalty and there is no RMD with Roth IRAs. So as for Roth IRA earnings distributions to be tax-free, the account must have been opened for five years and the distributions must be made after reaching age 59 1/2. If you meet the 5-year rule but not the 59 1/2 year regulation, distributions in excess of your contributions might be taxable and subject to a ten percent penalty.
1. No RMD - With Roth IRAs, there's no RMD at age 70 1/2. This means a Roth IRA owner is never required to make a distribution out of their Roth IRA. As a result, Roth IRAs can grow, untaxed, during the lifetime of the owner, allowing a larger legacy for their beneficiaries.
2. 0% Effective Tax Rate - Qualified distributions from Roth IRAs aren't subject to income tax...ever. This means you are unaffected by future tax increases as your effective tax rate is always the same...zero.
3. Conversion Opportunities - Beginning after January 1, 2010 anybody, irrespective of their income level, may convert traditional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be delayed into 2011 and 2012. If you do not have enough money set aside to do a 100% conversion you can do partial conversions.
4. College Costs - Because Roth IRA contributions might be withdrawn, tax-free, penalty-free, at any time, this kind of contributions can be a tax-free future funding source for your child's school expenses.
