September Focus - Premature Distributions from IRAs
The current economic conditions have left many individuals feeling like they have no choice but to tap into their retirement savings in order to make ends meet. For some, the dilemma is deciding between withdrawing from retirement savings or taking consumer loans. Making withdrawals from retirement accounts may seem like the better option as there are no repayments due; but the negative impact of making early distributions can be far reaching, especially for individuals who are under the age of 59 ½ when the distribution occurs. In this article we will focus on early distributions from IRAs-including Roth IRAs, and the possible financial impact of those distributions.
Tax Impact
Except for amounts attributable to nondeductible contributions, rollovers of after-tax amounts and Roth IRA conversions and contributions, distributions from IRAs that are not rolled over are taxable and will increase the IRA owner's taxable income for the year that the amount is withdrawn from the IRA. For those who are close to the top of their tax bracket, the distribution could push them into a higher tax bracket and increase the income tax that they would pay on some of their other income received during the year. As a result, the net effect of the distribution could be less than anticipated, as a portion of the distribution would be lost to higher income taxes.
Early Distribution Penalty
If the distribution occurs before the IRA owner reaches age 59 ½, a 10% early-distribution penalty will be owed to the IRS on any taxable amount of the distribution, unless the IRA owner qualifies for an exception to the penalty. These exceptions include the following:
- The distribution is not more than the cost of the IRA owner's medical insurance, if the medical insurance is for the IRA owner, his spouse, or his dependents if all of the following conditions apply:
- He lost his job.
- He received unemployment compensation paid under any federal or state law for 12 consecutive weeks because he lost his job.
- He receives the IRA distributions during either the year he received the unemployment compensation or the following year.
- He receives the distributions no later than 60 days after he has been reemployed.
- The IRA owner has unreimbursed medical expenses that are more than 7.5% of his adjusted gross income. The IRA owner does not have to use itemized deductions to get this exception.
- The IRA owner is disabled.
- The IRA owner is the beneficiary of a deceased IRA owner, and the distribution is taken from an inherited/beneficiary IRA.
- The distributions are being taken under a substantially equal periodic payment (SEPP or 72(t)) program.
- The distributions are not more than the IRA owner's qualified higher education expenses.
- The distribution is used to buy, build, or rebuild a first home.
- The distribution is due to an IRS levy on the IRA.
- The distribution is a qualified reservist distribution.
The 10% early distribution penalty can seem like a non-issue, until tax time, when it must be paid. Consider that a distribution of $20,000 would mean a penalty of $2,000.
Loss of Tax-Deferred Growth
Withdrawing any amount from the IRA before retirement means that the amount will no longer benefit from compounded tax-deferred growth, where earnings accrue upon earnings because the taxes on those earnings are not paid until the amount is withdrawn from the IRA. In the case of Roth IRAs, the loss is even more severe as those earnings would eventually be tax-free.
Weigh the Pros and Cons
Before taking an early distribution from an IRA, the IRA owner should weigh the pros and cons. These include giving consideration to whether any income tax, early-distribution penalty or the loss of tax-deferred growth outweigh the benefits received from the use of the amount withdrawn. In some cases, it may make better financial sense to withdraw the amount. For instance, if the individual needs to pay off high interest credit card debts, the benefits of paying off those credit card balances may outweigh the benefits of leaving the funds in the IRA. In order to make a proper determination, an analysis should be done to compare the net financial impact of each choice.
Conclusion
Careful consideration must be given to the impact a withdrawal can have on the IRA owner's tax and financial profile. Where possible and permissible, the amount can be rolled back to an IRA within 60-days of receipt, resulting in the distribution being restored to the IRA and excluded from the individual's income. In instances where the funds are needed on a short term basis, the individual should consider taking a loan from other sources - including family members - as the cost of those loans may be far less than the cost of raiding the IRA.
Detailed information on distributions from IRAs is available in IRS Publication 590, available at www.irs.gov. Question of the Month
Question: An individual just graduated from college and received a gift of $5,000 from his grandmother. He will start working next month, but he wanted to fund a Roth IRA now. Can he make his Roth IRA contribution from the $5,000 even though he has not received any compensation as yet?
Answer: Yes. The funds used to make IRA contributions can come from any legitimate source. Therefore, as long as he receives eligible compensation for the year that is at least the amount of his IRA contribution, the contribution can remain in the IRA. If his compensation is less than his IRA contribution amount, then he needs to remove the excess amount by October 15 of next year.
The September 2008 issue of Ed Slott's IRA Advisor is now available online. The areas covered include the following:
- Make Sure Qualified Plans Stay That Way... or Else
- Plan Disqualification
o Plan Document Failures
o Operational Failures
o Demographic Failures
o Employer Eligibility Failures
- The Results of Disqualification
- Corrections Under the Employee Plans Compliance Resolution System ("EPCRS")
- Advisor Action Plan
- Reference Chart: 2008 Limitations when Individuals Own or Participate in Multiple Retirement Plans. This chart shows you the maximum amount that can be contributed in 2008 to all types of company plans and IRAs, specifically when a client is active both as an employee of a company and as a self-employed business owner.
Guest IRA Expert
Denise Appleby, APA, CISP, CRC, CRPS, CRSP
Grayson GA
Be sure to review the September issue and post your questions on our message board at http://www.irahelp.com/phpBB/index.php?area=, where some of the best experts in the retirement field gather to discuss technical issues. 
