Premature Distribution
I have client who wants to take a premature distribution from her Rollover IRA in 2011 to pay off debts. She is working fulltime and just wants to clear out the debt and is aware of the penalty & taxes. I guess this is more of a “piece of mind” move on her part. Questions:
1. Is there a requirement to withhold on this distribution? Income in 2011 is expected to be 50K and the distribution is around 20K.
2. Debt is currenty at 3.1%. Are there any other strategies to recommend? I would expect her to increase her 401K and Roth contributions dramatically when she is free of debt, due to the fact she has no other debts.
Any thought or comments?
Thanks,
pko
Permalink Submitted by Alan Spross on Sat, 2010-11-27 20:10
pko,
1) IRA distribution withholding is strictly optional, but the default rate is 10% if IRA owner does not specify with respect to withholding.
2) The interest rate on the debt should dictate how fast to retire it in relation to making simultaneous retirement plan contributions. Generally if the rate is the usual 20% plus CC rate, the debt should be retired before contributions are made in excess of the % needed to get the 401k match. Therefore, contribute up to match limit, retire debt next, then contribute in excess of match or to IRA. If the rate was low, eg debt owed to a relative or a low home equity rate, the urgency should be less. But if she just has a compulsion to retire the debt to sleep at night, any other recommendations would probably not fly. Her job security should also be considered before rushing to pay off the debt. The 3% rate applies to net worth?
Since there are no tracing rules with respect to the penalty on early distributions, perhaps she qualifies for an exception based on certain other expenes paid earlier in the year, eg high medical, higher education, etc. If none this year, perhaps it is worth waiting another 5 weeks and take the distribution in January to keep the option open for a penalty waiver to develop next year. Here is where job security comes in again, because if she lost the job and collected 12 consecutive weeks of UC, then the medical insurance penalty exception could be applied.
Permalink Submitted by Anonymous (not verified) on Sat, 2010-11-27 20:33
Thanks alan. Those are some good points.
The only reason I brought up the withholding issue was that I remember a few months back, I played around with TurboTax and it came up with some addtional penalties (beyond the 10%) when taking a premature distribution. Could not figure out why?
The 3.1% is the current interest rate on the debt, ie. very low. I tend to agree to wait, since a 10% penalty on 20K is about 3 years of interest right of the bat. So, it may actually make sense to gradually pay it down, BUT that conflicts with compulsion issue.
pko
Permalink Submitted by Alan Spross on Sat, 2010-11-27 20:48
Perhaps that prior penalty situation could have been:
1) Higher 25% penalty for SIMPLE IRA distribution prior to 2 year waiting period
2) Or a mixture of early distribution and excess contribution 6% penalties?
I didn’t even consider that the 3.1 was the actual INTEREST Rate it is so low. But still commented on that possibility.