IRA distribution rules are a mine field. One wrong move and you could find yourself faced with high taxes and penalties that could wipe out years of savings and investment. Complicating matters is the Darwinian evolution of IRAs which have taken place since the first IRA was introduced in '74 with the enactment of the Worker Retirement Income Security Act (ERISA ). Since '74, IRA policy have changed dramatically and laws was enacted to rigorously punish those who don't follow the regulations, to the letter of the rule. IRAs come in several flavors but, for purposes of this article we'll focus on the two chief types of IRAs: Traditional IRAs and Roth IRAs.
Approaches for Minimizing Penalties on Early Distributions
Normally, 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're specific IRA distribution rules that can be used to avoid the burden of this early withdrawal penalty.
1. Using IRA Funds to Purchase or Build Your First Home - Up to $10,000 might be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to buy, build or rebuild a first house for yourself, your spouse, you or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 Medicinal Bills - Penalty-free early distributions can be made if the funds are used to pay unreimbursed medical costs which exceed 7.5 % of your adjusted gross income. There's no obligation to itemize deductions in order to be eligible for this exception.
3. Using IRA Funds for School Expenses - Conventional IRAs can also be tapped to help fund school costs; however, the taxable amount of the distributions from these IRAs will be subject to 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 Contributions withdrawn are not matter of the 10% penalty and there's no RMD with Roth IRAs. So as for Roth IRA earnings distributions to be tax-free, the account must have been opened for 5 years and the distributions must be made after reaching age 59 1/2. If you meet the five-year rule but not the 59 1/2 year regulation, distributions in excess of your contributions might be taxable and matter of a 10% penalty.
1. No RMD - With Roth IRAs, there is 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. Because of this, Roth IRAs can grow, untaxed, during the lifetime of the owner, permitting a larger legacy for their beneficiaries.
2. 0% Effective Tax Rate - Qualified distributions from Roth IRAs are not subject to income tax...ever. This means you are unaffected by future tax increases as your effective tax rate is constantly the same...zero.
3. Conversion Possibilities - 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. University Costs - 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.
