Retirement plans like IRAs, Keoghs, SIMPLEs and 401(k) plans are packed with wonderful tax incentives to encourage us all to save for our retirement years, but also all sorts of possible penalties. You can be penalized if you put in too much money in one year; there's a penalty if you take money out too soon; and, to bring things full circle, there can be a penalty if you fail to take enough money out once you reach age 70 1/2.
Work through the Interview for this issue if you think you might have violated a rule. All is not necessarily lost if you discover a rule has been broken. If you have a good reason—say you failed to take the minimum required amount out of a regular IRA because the sponsor erred when figuring the mandatory withdrawal—ask the IRS to waive the penalty.
The government doesn't want you tapping into your retirement nest egg early so a 10% penalty tax applies if you withdraw funds from a company retirement plan, such as a pension, profit-sharing plan or a 401(k), before a certain age—usually age 59 1/2. Sometimes, of course, you have to take the money early, as you might if you quit or lose your job.
Since the point of the tax benefits for retirement plans is to help make sure you'll have money to live on in retirement, the 10% penalty is designed to encourage you to roll over such payouts into an IRA or new employer's plan. Such a rollover lets you dodge the 10% penalty because, once inside the IRA or employer's plan, the money is still tied up until you're at least 59 1/2.
There are, of course, the inevitable exceptions to the early-withdrawal penalty. It does not apply if:
When an IRA is involved, there are even more exceptions to the penalty. Up to $10,000 can be withdrawn penalty free at any age to help pay to buy or build a first home, for example, and any amount can be withdrawn to pay higher education expenses for yourself your spouse, a child or grandchild.
Even if you avoid the penalty, the money you receive will be taxed as ordinary income in the year you receive it (unless it represents after-tax contributions or qualifying withdrawals from a Roth IRA). As noted above, you can avoid the penalty by rolling the payout from the company plan into an IRA. That choice also puts off the tax bill on the benefits and permits continued tax-deferred growth of your nest egg. That triple benefit gives the rollover route almost irresistible appeal.
Tapping a Keogh plan before age 59 1/2 will generally trigger a 10% early-withdrawal penalty, but the same exceptions apply as to a company plan. That means, for example, that you can get at your money without penalty as early as age 55 if you have closed the business that has generated the self-employment income going into the Keogh.
SPECIAL EXCEPTIONS FOR HURRICANE VICTIMS: As part of its efforts to aid victims of Hurricanes Katrina, Rita and Wilma, Congress has waived the 10% penalty for early plan withdrawals and will allow taxpayers to pay the taxes on such withdrawals over a three year period. To qualify for this break, your principal residence must have been in the area struck by one of the three storms and you must have suffered an economic loss from the storm. If you qualify, up to $100,000 can be withdrawn from IRAs or other retirement plans penalty-free and the tax bill stretched out over three years. If you are able to restore the funds to your retirement account within three years, you can recover the taxes paid earlier by filing an amended return.
Before withdrawing funds from a retirement plan, you should check to see if you could borrow from the retirement plan. That would avoid both the penalty an the taxes if you can repay the funds within 5 years.
The IRA rollover has almost irresistible appeal since it allows you to both avoid the early withdrawal penalty and continue to postpone paying tax on the benefits. To add even more encouragement, the law now demands that if you don't have the money sent directly to an IRA (or to a new employer's retirement plan, if it accepts such rollovers), 20% of the payout will be withheld for the IRS. This applies to plan distributions that go to employees who retire, quit or lose their jobs. (Note: The mandatory 20% withholding does NOT apply to penalty-free withdrawals taken by hurricane victims, as discussed above.)
This is not a new tax, but rather a forced prepayment of a tax bill you may or may not owe. If you do roll over the payout yourself, no tax would be due. Even if tax is due on the payout, the 20% rule may send too much to the IRS. In either case, you couldn't get your money back until you file your tax return for the year of the payout.
Although you can still legally handle the rollover yourself—by taking the payout and depositing it in an IRA within 60 days—the withholding rule might make that impossible to do. After all, unless you agree to a direct IRA rollover, 20% of your money will be shipped off directly to the IRS. Unless you can come up with an equal amount from another source, you won't have enough to put the full payout amount into an IRA. Any part of the payout that's not in an IRA within 60 days will be taxed and possibly penalized.
Fortunately, there's an easy way around the withholding trap and employers are required to tell departing employees about it. Just have your employer send the money directly to the IRA—or a number of IRAs—of your choice. If you're taking a new job and the new employer's retirement plan accepts rollovers from other qualified plans, you can ask your employer to make a direct rollover to that plan. In either case, as long as the money never passes through your hands, there is no withholding.
Even if you want to spend part of the money right away, have it transferred first to an IRA. You can then tap the IRA without worrying about withholding.
In some circumstances, however, rolling the money into an IRA could be a costly mistake. If you qualify to use ten-year averaging to reduce the tax on your payout, rolling the money into an IRA automatically wipes out that option. Averaging can't be used for money coming out of an IRA. If averaging makes sense for you, you'll have to put up with the withholding rule.
A direct transfer could also be a mistake for someone leaving a job between age 55 and age 59 1/2. If you plan to spend some of the money, it will be taxed regardless of your age. But age plays a role in whether you'll be hit with the 10% penalty for early withdrawal. That penalty applies if you're under age 55 when money comes out of a company plan (after you leave the job) but it applies up to age 59 1/2 when money comes out of an IRA.
If you're over 55 but not yet 59 1/2 when you get the payout, using a direct rollover to put the money in an IRA would extend the threat of the early-withdrawal penalty. If you're in this situation and know you'll need part of the money before age 59 1/2, ask your employer to split the payout so part goes directly to an IRA and the rest to you. Although the money you receive will be subject to withholding, you'll avoid the penalty.
Withholding applies to almost all payouts from company retirement plans. Not covered are distributions in the form of an annuity or a series of payment spread over ten years or more, or required distributions made because you're over age 70 1/2. Since such payments can not be rolled over into an IRA, there's no mandatory 20% withholding to encourage the rollover.
A. The 60-day rollover period begins when you receive the distribution from the company plan. In a case in which it took a taxpayer three weeks to get his check in the mail, for example, the IRS reaffirmed that the 60-day clock didn't start ticking until the day the check arrived.
What if the IRA owner dies while there's still money in the tax shelter?
First, the 10% early-withdrawal penalty does not apply to distributions to beneficiaries. The beneficiary of the account can cash in the IRA without worrying about that penalty, regardless of how old the owner was at the time of death or how old the beneficiary is when he or she claims the cash.
The potential problem, however, is that the money pulled out of a traditional IRA is taxable to the beneficiary (except to the extent that it represents nondeductible contributions). This is a major-league exception to the general rule that inheritances are tax-free. And, it could create a substantial tax bill if the IRA is cashed in all at once. The heir may be better off leaving the money in the IRA to continue taking advantage of the tax shelter. Of course, the IRS has something to say about that, too.
Fortunately, though, changes made by the IRS in 2001 greatly simplify things. Prior to the change, the rules for the beneficiary depended on the age of the IRA owner when he or she died. Now, that doesn't matter. If the beneficiary is the widow or widower or the IRA owner, he or she may claim the IRA as his or her own and put off distributions until age 70 1/2, at which time the regular minimum withdrawal rules would kick in. Otherwise, beneficiaries can stretch payouts over their own life expectancies. A 40-year-old has a 42.5 year life expectancy, according to IRS tables, and therefore would have to take 2.3% (1 divided by 42.5) of the amount in the account in the first year, 2.4% (1 divided by 41.5) the second year, and so on. If no beneficiary is named on the account — so the IRA passes to its new owner under a will or the state's intestate rules — the account must be cleaned out within five years.
The rules discussed above are for traditional IRAs. The rules are different — and much better — for Roth IRAs. That money will come to the person who inherits it tax-free.
Even though the government has no stake in the Roth account at the time of the owner's death, Congress doesn't want the heir to perpetuate the tax shelter forever. As for how quickly you must clean out an inherited account, if you are the widow or widower of the Roth IRA owner, you can claim the account as your own. In that case there would be no required withdrawals. Otherwise, a named beneficiary must withdraw everything from the IRA within five years of the death of the owner or to begin withdrawals within one year of the death of the owner, based on the beneficiary's own life expectancy. If no beneficiary is named, the only choice is to cash out the entire IRA within five years.
The life-expectancy tables play a key role in an exception to the 10% penalty for withdrawals from regular IRAs prior to age 59 1/2. The penalty is waived if the withdrawal is part of a series of roughly equal payments tied to your life expectancy. If you have a substantial amount in your IRA accounts, this rule may permit you to claim penalty-free withdrawals of thousands of dollars a year.
To use this loophole to crack an IRA nest egg early, you must stick with the lifetime payout schedule for at least five consecutive years and until you're at least 59 1/2. Violate either of those requirements and the 10% penalty would be applied retroactively to your pre-59 1/2 withdrawals.
Here's an example of how the rule works. If you are 55 and have no IRA beneficiary, your life expectancy is 29.6 years. Assume you have a total of $100,000 in your IRA accounts. Spreading that amount over more than 29 years would put your annual withdrawal at just $3,378.
Fortunately, the IRS allows you to take a reasonable interest rate into account when figuring your penalty-free payouts. Unfortunately, these days the acceptable rate is paltry. Unlike in the past, when taxpayers could set their own "reasonable rate", the IRS now sets a cap. In the fall of 2006, it was 6.03%.
If you start such life-expectancy-based withdrawals at age 55, by the time you reach 60 you will be free to change the withdrawal schedule—you will have met both the five-year and the age 59 1/2 requirements. From then on you can take out more or less money without worrying about the recapture rule.
While such pre-59 1/2 withdrawals dodge the 10% penalty, the money pulled out of the traditional IRA would be taxed, except to the extent it is a return of nondeductible contributions.
Traditional IRAs were created to help you accumulate money for your retirement not build up a pile of money for your heirs to inherit. So, the law demands that you begin pulling money out when you reach age 70 1/2. The minimum withdrawal schedule is designed to get all your money out and taxed by the time you die, or at least by the time your designated IRA beneficiary dies. If you don't take out the minimum required each year, the IRS will claim 50% of the amount you fail to withdraw.
The first mandatory distribution must be made by April 1 following the year you reach age 70 1/2.
In a stunning development in 2001, the IRS greatly simplified the method for figuring minimum withdrawals. And, not only are the new rules blessedly simpler than in the past, they are actually beneficial for the vast majority of taxpayers by allowing them to slow down withdrawals (if they want to) and stretch out this tax shelter. Minimum withdrawals are based on your life expectancy and, until 2001, the life expectancy of the oldest beneficiary named on the account. If you had several IRAs, the minimum withdrawal from each was based on the amount in the account at the end of the previous year and your age, or the ages of you and your oldest beneficiary. It was, to be frank, a royal pain.
But now, minimum withdrawals are based on joint life expectancies that assume you have a beneficiary who is ten years younger than you are. You use this method even if you don't have a named beneficiary. Besides being simpler, this also stretches out withdrawals for anyone whose beneficiary is less than ten years younger, as well as those who haven't named a beneficiary. (You should name a beneficiary, though, because a named beneficiary has more flexibility on using the account than someone who inherits an IRA under a will.)
Under the new rules, if you turn 70 in the year you reach 70 1/2 (in other words, your birthday falls before July 1), the life expectancy you use for figuring the first mandatory withdrawal is 27.4. You would add up the total in all your IRAs at the end of the previous year, divide that amount by 27.4 and, voila, you know how much you have to withdraw.
Once you determine the minimum withdrawal it's up to you which account or accounts to tap into to meet the minimum distribution requirement. Say, for example, that you have five accounts and you determine you need to withdraw a total of $15,000. If you want to take the full amount out of a single IRA say the one returning the lowest return on your investment that's okay. You don't have to take money out of every IRA you own. Also remember that you can always take MORE than the minimum.
There is one exception to the "everybody uses the same life expectancy" rule. If your beneficiary is your husband or wife — and he or she really is more than ten years younger than you are — you can use an even longer life expectancy to figure your minimum withdrawals. That would let you stretch them out even more and keep the tax shelter going.
As noted earlier, when you reach age 70 1/2, you have until April 1 of the following year to make the first mandatory withdrawal. If your 70th birthday fell in the first half of 2006, for example, you must make a withdrawal for 2006. But you have until April 1 of 2007 to do it. Putting off the withdrawal would let you postpone reporting the amount on a tax return until you file your 2007 return in 2008. But it would also mean doubling up, because after the first year, required withdrawals must be made by December 31. If you delay your first withdrawal until the following April 1, you will be required to take two distributions during that calendar year
If you have a good reason for failing to make the mandatory withdrawal — say the IRA sponsor provided you with incorrect balance information or you didn't understand the life-expectancy method — the IRS can (but doesn't have to) excuse the 50% penalty on the amount you should have withdrawn. The penalty is figured on Form 5329, Return for Individual Retirement Arrangement and Qualified Retirement Plan Taxes. If you think you have a good enough excuse to get the IRS to waive the penalty, attach your explanation to the form. If the IRS agrees, you'll get a refund of the penalty tax.
The mandatory withdrawal rules for Keogh plans are basically the same as for IRAs.