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 before age 70 1/2, you will pay 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 apply if:
You’re disabled.
Your beneficiary receives the distribution from your retirement plan after your death.
You receive distributions that represent equal installments over your life expectancy or the life expectancy of you and your beneficiary.
You receive a distribution when you’re at least 55 years old and you’ve left your job. (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.
You received the distribution due to an IRS levy.
You received the distribution as 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 does not apply if:
You are unemployed and you use your IRA distributions 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 first home.
Even if you don’t pay a penalty, the distribution will be taxed as ordinary income (doesn’t apply to Roth IRAs).
Keogh plans are subject to the same rules and exceptions as a company retirement plan.
If your retirement plan allows you to borrow from it, you have 5 years to pay it back without incurring the 10% early-withdrawal penalty.
Rolling over your company pension plan into an IRA helps avoid the 10% early-withdrawal penalty. If you decide to handle the rollover yourself, you must complete the rollover within 60 days from the date that you receive the money. In addition, the company must withhold 20% of the payout for taxes. However, if you have the company send the money directly to the trustee of your IRA (known as a direct rollover), no money will be withheld.
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.
If you leave your job between the ages of 55 and 59 1/2, a direct transfer from your retirement plan to an IRA will subject you to the 10% early-withdrawal penalty if you withdraw money from the IRA before you reach 59 1/2.
If you receive distributions as a series of installment payments spread over ten years or more, or you receive required distributions because you’re over age 70 1/2, you’re not subject to the 20% withholding rule.
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, just as it would have been 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 taking the minimum required distribution until age 70 1/2. If you’re not a spouse, you can use the IRS life expectancy tables to determine your distribution over your life expectancy.
Example: Your father died in 2006 and you’re the designated beneficiary of your father’s traditional IRA. You are 53 years old in 2007. According to the IRS tables, your life expectancy in 2007 is 31.4. If the IRA was worth $100,000 at the end of 2006, your required minimum distribution for 2007 is $3,185 ($100,000 / 31.4). If the value of the IRA at the end of 2007 is again $100,000, your required minimum distribution for 2008 would be $3,289 ($100,000 / 30.4). Instead of taking yearly distributions, you can choose to take the entire distribution in 2011 or earlier.
You can elect to take the entire amount by the end of the fifth year following the year of the owner’s death. 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 must be taken by the end of the fifth year.
Roth IRAs have different guidelines. If you inherit a Roth IRA, the money is tax-free. If you inherit the Roth from your spouse, you can treat it as your own. This means that there are no required withdrawals. However, if you’re not the spouse of the decedent, you must withdraw everything from the Roth IRA within 5 years of the owner’s death or begin withdrawals within 1 year of the owner’s death, based on your life expectancy (the beneficiary’s life expectancy).
You can receive distributions from your traditional IRA that are part of a series of substantially equal payments over your life, or over the lives 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 one 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 1/2. 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 1 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.
You must make your first mandatory withdrawal by April 1 following the year that you reach 70 1/2:
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 the following April.
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 1 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 one account or from several accounts. For example, if you’re required to withdraw $10,000 a year and you have two accounts, you can withdraw the entire amount from just one 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, such as poor health, for not withdrawing the minimum amount.
Keogh plans follow the same mandatory-withdrawal guidelines as IRAs do.