Tap Your IRA - Avoid the Early Withdrawal Penalty - February 2011
Richard Scrivanich - Partner

When you withdraw money from your traditional IRA, you probably will owe income tax. Moreover, the R in IRA stands for retirement, so the tax code discourages early withdrawals. You probably will owe a 10% penalty tax if you take money from your IRA before age 59½. This surtax can be especially painful for individuals facing financial difficulties.

Example 1: Matt Peters was laid off from his publishing job at age 52. He is working as a freelance editor this year, but his income is sharply lower than it had been. Matt takes $10,000 from his IRA to help pay his bills.

This year, Matt's income will put him in the 15% tax bracket. Therefore, he owes $1,500 in federal income tax on his IRA withdrawal: 15% of $10,000. Matt also owes a 10% surtax of $1,000 (10% of $10,000) because he is under age 59 ½. As you can see, the yearly withdrawal penalty increases his tax obligation sharply, from $1,500 to $2,500.

10% solutions
Fortunately, the tax code includes several exceptions to this 10% penalty.
They include:

• Death. You won't owe a penalty if you are the beneficiary of an IRA after the IRA owner's death.
• Disability. You can take penalty-free distributions from your IRA if you are disabled.
• College costs. You can withdraw an amount equal to or less than what you pay for higher education expenses in a calendar year.
• Home acquisition costs. You can use the distributions to buy, build, or rebuild a home.
• Medical insurance. If you lose a job and collect unemployment insurance for at least 12 consecutive weeks, you can tap your IRA for an amount up to your costs for health insurance.
• Medical expenses. If you have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income, you can withdraw the excess amount from your IRA.
• Annuity payouts. Distributions avoid penalties if they are taken as a series of substantially equal periodic payments (SOSEPP).

The two-year hitch
Some of these exceptions come with fine print. For the home acquisition exception, the home buyer can be the IRA owner, the IRA owner's spouse, either spouse's ancestor, or either spouse's descendant. You can take money from your IRA to provide your son with a down payment on a home, for example, and avoid the 10% surtax.

In addition, every home buyer must be a "first-time" buyer. That is, he or she cannot have owned a principal residence in the two years prior to the purchase. If the buyer is married, both spouses must pass this two-year test.

Finally, this exception to the 10% penalty is limited to $10,000. That $10,000 is a lifetime amount, per taxpayer. Thus, a married couple can each withdraw up to $10,000, penalty free, to finance a home purchase if all the other requirements are met.

Precise payouts
Many taxpayers use a series of substantially equal periodic payments (SOSEPP) to take money from an IRA penalty free before 59½. A SOSEPP can be used by any taxpayer, so you don't have to fit into a particular situation (disabled, first-time home buyer, and so forth) to qualify. There are several ways to calculate a SOSEPP, which means that you have a great deal of flexibility in determining how much you want to take from your IRA.

On the other hand, once you begin a SOSEPP you must maintain it for at least five years or until age 59 ½, whichever comes later. If you withdraw more or less than the required amount, you will owe the 10% penalty on all your withdrawals before age 59 ½.

The more the merrier
Now for the good news: a Tax Court case in 2009 indicated that you can use more than one exception to increase penalty-free IRA withdrawals. In this case (Benz v. Commissioner), the taxpayer was taking a SOSEPP. One year, she took out the SOSEPP amount and also withdrew $22,500 to pay college costs for her son. She did not pay any penalty on these withdrawals.

The IRS allowed penalty-free withdrawals for her college costs, under the exception for higher education expenses, but the IRS also said that taking out the extra money for college spoiled her series of substantially equal periodic payments. Therefore, the IRS assessed a 10% penalty for some of her IRA withdrawals.

The Tax Court decided in favor of the taxpayer, ruling that her penalty-free withdrawal for college costs did not interfere with her scheduled SOSEPP. Therefore, it appears that you are allowed to use more than one exception to the 10% penalty for early IRA withdrawals.

If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.