Getting Around the IRA Early-Withdrawal Penalty

Also, more on calculating your minimum distribution.
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Last week's

column on how to take money out of your IRA brought a flood of reader questions. It seems like almost everybody's got a vested interest in IRAs, so I'll answer some of the most frequently asked questions.

I guess I thought I could get away with oversimplifying the 10% penalty on taking distributions before age 59 1/2. Four of you --

Ron Fong

,

Dave Cooper

,

Ken Mueller

and

Jim Vaughan

-- nailed me on that one. Actually, there are at least seven exceptions. There's no penalty for early distributions:

  • Made to the beneficiary on or after the death of the IRA owner.
  • Attributable to a disability.
  • For medical purposes in excess of 7.5% of the owner's adjusted gross income.
  • For health-insurance premiums for IRA owners receiving unemployment compensation.
  • To pay for a first home (maximum $10,000).
  • To pay for qualified higher-education expenses (maximum $10,000).

An additional exception that many of you pointed out has to do with section 72(t) of the tax code. This "72(t) distribution" is defined as "part of a series of substantially equal periodic payments made (at least annually) for the life or life expectancy of the individual, or the joint-life expectancy of the individual and his or her designated beneficiary."

An email from Ron Fong explains the rest: "You must take the same amount each year for five years or until you reach 59 1/2, whichever is longer." And you can't change your mind at any time once you start taking the distributions. These distributions are still taxable, of course, but there's no 10% penalty.

There are some intriguing planning options on the 72(t) idea. In addition to taking a premature distribution without penalty, you can

split

your IRA. Take, for example, a 55-year-old IRA owner with a current account balance of $500,000 and a monthly income need of $2,000 beginning this year.

Because he isn't yet 59 1/2, a distribution would be considered premature and would incur a 10% penalty in addition to the ordinary income tax. But he could split off $172,000 and put it into a "72(t) IRA" and begin immediate distributions of $2,000 a month. That way, the entire IRA is not locked into the 72(t) distribution plan. The balance, $328,000, could be left in the regular IRA and continue to defer taxes beyond age 59 1/2.

Required Beginning Date

Now let's look at a question regarding the noncalculation and recalculation methods for determining how much must be taken in distributions once an IRA owner turns 70 1/2. You must choose between one of the two methods, and your decision is irrevocable.

Bill Groscup

asks for further clarification of my example, in which the actuarial tables called for a 20-year payout period: "In the nonrecalculation method, if you take 1/20 out each year but your remaining IRA is making 5% a year or more, it seems like you never get to zero. What am I missing?"

James Donnelly

adds: "It would seem the noncalculation method ignores the fact that the remaining balance of the IRA would (hopefully) continue to grow as an investment. If that occurred, would the owner be subject to penalties at the end of the 20th year because there was a balance?"

I had a problem with this at first, too, because it seemed too simple. But it is simple, in that regardless of how much it grows, the amount in the IRA must all be taken out by the end of 20 years in this example.

Here is the way attorney Bruce Kardon of

Financial Network Investment Corp.

puts it: "The fraction used to determine the minimum distribution amount is determined by simply subtracting one year from the prior year's denominator." So, in effect, the distribution formula calls for you take out 1/20 the first year, 1/19 the second and so on. By the 18th year, you would be withdrawing the equivalent of 1/3, the 19th year 1/2, and in the 20th year you would take out the remainder.

The obvious problem with this method is that if you outlive the actuarial table, you will also outlive the money coming from your IRA. How do you set up your IRA so you cannot outlive the distribution? You simply choose the other method: recalculation. Using recalculation, life expectancy and the amount you withdraw will be recalculated each year based on your (and possibly your spouse's) age at that point. Because life expectancy does not decrease by a full year for each year the IRA owner lives under the method, life expectancy never drops to zero while the owner is alive. By choosing the recalculation method, the IRA owner never outlives the income stream.

If one of your goals it to keep distributions as low as possible and to lessen the income-tax bite, one way to accomplish that is to use what is called the joint-life table with a designated beneficiary who is younger than you and choose the recalculation method. That will have the effect of stretching out minimum distributions over a longer period, minimizing income taxes and maximizing deferral. To consider doing this, you may need to have enough income from other sources to meet your needs.

Your email questions help me to know what to discuss in more detail. In case some of you think this is a simple subject, you should see the more-than-600-page book on IRAs sitting on my desk.

Next week, I'll discuss some of the rules that apply if an IRA owner dies before, or after, the required minimum distribution date. That 600-page book is starting to look like Mount Everest!

Have a good week!

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

Hayden@cwixmail.com.