Retirement plans, such as IRA, SIMPLE, Keogh, and 401(k) plans, allow you to save for your future. However, if you don’t follow the rules for these retirement savings vehicles, you can incur additional tax penalties. If you contribute too much money in a year, withdraw your money too soon, or fail to withdraw your funds by the required minimum distribution date, you may be subject to a tax penalty. Of course, there are exceptions to these penalties.
The purpose of putting money into a retirement plan is to save for your future, so you’ll pay a 10% early-withdrawal penalty if you withdraw money from your retirement plan early, usually before age 59 1/2. However, if you roll over your company pension plan into an IRA rather than withdrawing the money from it, you won’t pay a penalty.
There are exceptions to the 10% early-withdrawal penalty. The penalty doesn't generally apply to distributions from your employer plan or IRA if:
You’re totally and permanently disabled.
Your beneficiary receives the distribution from your retirement plan after your death.
You receive distributions as a series of substantially equal periodic payments based upon your life expectancy or the joint life expectancies of you and your beneficiary.
The distribution is received after separation from employment during or after the year you reach age 55. (50 for qualified safety employees). (This exception does not apply to IRAs.)
You use the distribution to pay medical expenses in excess of 7.5% of your adjusted gross income (AGI).
You received the distribution as a reservist while serving on active duty for at least 180 days.
Your qualified plan or IRA was forced to make a distribution due to a federal tax levy.
The distribution was made to an alternate payee under a qualified domestic relations order (QDRO). (This exception does not apply to IRAs.)
IRAs have additional exceptions to the 10% early-withdrawal penalty. The penalty for a distribution from your IRA does not apply if:
You're unemployed and have received unemployment compensation for at least 12 consecutive weeks and you use your IRA distribution to pay for health insurance premiums.
You use your IRA distributions to pay for higher-education expenses.
You use your IRA distributions (up to a $10,000 lifetime limit) to purchase, build, or rebuild a home for you, your spouse, or any child, grandchild or ancestor when that individual has not had an ownership interest in a main home for at least 2 years.
Even if you don't pay a penalty, the taxable portion of the distribution will be taxed as ordinary income.
Rolling over your company retirement plan assets into an IRA may allow you to take distributions while avoiding the (10%) early-withdrawal penalty. However, the reverse can also be true.
For example, if you separate from service after attaining age 55, you can generally take penalty-free distributions from the qualified plan. However, if you were to roll over the employer plan assets into your IRA, you would lose the ability to use this exception as it is not available for IRA distributions. You need to consider when you'll need the funds and consider the penalty exception(s) you may want to rely on before you decide whether or not to roll over your employer-sponsored retirement plan to an IRA.
If you choose to roll over your plan assets, you'll want to have the assets transferred in a direct rollover. A direct rollover means that the plan administrator will send the rollover distribution directly to the recipient IRA or employer plan. If you choose to take a distribution and roll it over yourself, mandatory federal income tax withholding from the distribution may make it difficult to fund the rollover contribution within the required 60-days because the amount of money you will actually receive will be the distribution amount less the amount that was withheld and paid to the government.
If you were born before January 2, 1936 or you’re a beneficiary of a plan participant who was born before January 2, 1936, rolling over your retirement plan distribution into an IRA prevents you from using the special ten-year averaging rules.
You may choose to not have withholding done on any distribution from a retirement plan that is not a rollover distribution. To make this choice, you will need to complete Form W-4P. By choosing not to have tax withheld you may be forced to make estimated payments to account for your tax liability. As a general rule, there will be no withholding done where it is reasonable to expect that the distribution will not be includable in gross income.
When you roll over your distribution from your retirement plan to an IRA, you have 60 days to complete the rollover, beginning on the day that you receive the check.
What if the IRA owner dies while there’s still money in the account?
Beneficiaries, regardless of the IRA owner's or beneficiary's age, don't have to worry about the (10%) early-withdrawal penalty. However, any distribution taken is taxable to the beneficiary to the extent it would have been taxable to the IRA owner, even though the funds are inherited.
If you inherit the IRA from your spouse, you can treat the IRA as your own and defer the minimum required distribution until you attain age 70 1 / 2. If you're not a spouse, you may still be eligible to use the IRS life expectancy tables to determine your required distributions over your life expectancy.
Example: Your father died in 2008 and you’re the designated beneficiary of your father’s traditional IRA. You are 53 years old in 2009. According to the IRS tables, your life expectancy in 2009 is 31.4. If the IRA was worth $100,000 at the end of 2008, your required minimum distribution for 2009 is $3,185 ($100,000 / 31.4). If the value of the IRA at the end of 2009 is again $100,000, your required minimum distribution for 2010 would be $3,289 ($100,000 / 30.4). Instead of taking yearly distributions, you can choose to take distributions of the entire account at anytime as long as the account is completely distributed. However, if there’s no designated beneficiary named by September 30 of the year following the year of the IRA owner’s death, the entire distribution may be subject to the 5-year rule.
If you inherit a Roth IRA, the money is generally tax-free provided it is a qualified distribution. To be a qualified distribution, the funds must have remained in the Roth account for 5 years before they are withdrawn. The 5 year holding period will include the amount of time that the funds were in the account during the lifetime of the deceased and will not start over when the beneficiary inherits the funds. If you inherit the Roth from your spouse, you can treat it as your own. This means that there are no required withdrawals during your lifetime. However, if you're not the spouse of the decedent, you must take required minimum distributions from the account or use the 5-year rule, depending upon the situation.
You can receive distributions from your traditional IRA that are part of a series of substantially equal payments based upon your life expectancy, or over the joint life expectancies of you and your beneficiary, without having to pay the 10% early-withdrawal penalty, even if you receive these distributions before you’re age 59 1/2. You must use an IRS-approved distribution method and you must take at least 1 distribution annually for this exception to apply.
In addition, you must continue making these withdrawals for at least 5 years and until you’re at least 59 1/2. If you don’t, you’ll have to pay the 10% early-withdrawal penalty. You may have to pay it even if you modify your method of distribution after you reach age 59 ½ if you have not yet received the payments for at least 5 years. in that case, the tax applies only to payments distributed before you reach age 59 1/2.
Although this installment method saves you the 10% early-withdrawal penalty, you’ll still have to pay taxes on any amount not considered a return of your nondeductible contributions.
You must begin withdrawing money from your traditional IRA by April 1st of the year following the year that you reach age 70 1/2. The IRS will access a 50% penalty if the minimum required amount isn’t withdrawn.
If your 70th birthday occurs between January and June, you’ll turn age 70 1/2 before the end of that year and you must begin taking your required minimum distribution from your IRA by April 1st of the following year. However, you may want to take your first distribution in the year you turned age 70 1 / 2 to avoid having to take two distributions in the next calendar year.
If your 70th birthday is after June 30, your first minimum required distribution would be for the next year and you could wait until April 1st of the following year to take it.
Minimum withdrawals are based on life expectancy and once your minimum required distribution has been determined, you can take the full amount from just 1 account or from several accounts. For example, if you’re required to withdraw $10,000 a year and you have 2 accounts, you can withdraw the entire amount from just 1 account, or you can split the distribution between both accounts.
If you fail to withdraw the minimum required amount, you’ll be subject to a 50% penalty. However, the IRS might waive the penalty if you have a good reason for the failure, such as poor health.