Editor's note: As a special feature for April, TheStreet.com is offering a seven-part series on maximizing your IRA. This installment is Part 3. Click here for Part 1, Part 2, Part 4, Part 5, Part 6 and Part 7.
There are substantial penalties to be paid for making withdrawals from an IRA before you reach age 59 1/2 or, in the case of a Roth IRA, if withdrawals occur within the first five years of a contribution. So investors need to make every effort to plan ahead and should have a reserve fund established for emergencies.
Early withdrawals from traditional IRAs are subject to a 10% penalty in addition to the payment of income taxes on the amount withdrawn. There is a loophole that lets you avoid a penalty if you withdraw money from an IRA and pay it back within 60 days. However, no investor should rely on this form of short-term financing.
There are eight legitimate exceptions that will avoid the 10% penalty:
The IRA owner becomes disabled.
The IRA owner dies.
The IRA owner elects to take "substantially equal periodic payments" from his IRA over his remaining life expectancy.
Withdrawals are used to pay for medical expenses exceeding 7.5% of adjusted gross income.
Withdrawals are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for 12 weeks.
Withdrawals are used to make a first-time home purchase. (This exception is subject to a lifetime maximum of $10,000.)
Withdrawals are used to pay higher education expenses for the IRA owner or other eligible family members.
Withdrawals are used to pay back taxes because of an IRS levy.
I should emphasize that, while these exceptions will avoid penalties, they are still to be avoided if at all possible (especially No. 2). When withdrawals are made before retirement, your tax-deferred compounding is halted, and there is no way to recover that loss.
At the other end of the life cycle, owners of traditional IRAs are subject to penalties if they do not withdraw a sufficient amount each year starting at age 70 1/2. These distributions must begin by April 1 following the year that the age trigger is reached. Otherwise, a 50% extra tax on the amount not distributed will be assessed.
Roth IRAs do not have any mandatory distribution requirements, but early withdrawal penalties still apply and are made even more stringent because of the five-year rule. Qualified distributions (where no income tax is due) from a Roth IRA must have been held for five tax years and must be made:
- After the age of 59 1/2, or
- When you die or become disabled, or
- For the payment of first-time homebuyer expenses.
In one sense, the penalties on distributions from Roth IRAs are not as severe as they may seem at first glance because of the ordering rules. These rules dictate that distributions must come first from the annual contributions over the years, then from conversion contributions and, finally, from earnings.
So, for example, if we start with a $4,000 contribution that has grown to $6,000 over the last couple of years and then withdraw $3,000 prematurely, that $3,000 comes from original contributions that have already been taxed, and there will be no tax or penalty due. If, however, we withdraw $5,000, then $1,000 is coming from earnings, which will then be subject to income tax and also subject to a $100 penalty.
Perhaps the more important factor in this instance is that the withdrawal is gone from the Roth IRA portfolio and the holder has given up tax-free compounding on that amount from that point until withdrawals take place in retirement.
Should you pass away with assets remaining in an IRA, it would clearly be advantageous for that IRA to be a Roth IRA. Traditional IRAs count as part of your estate, and beneficiaries will still have to pay income tax on the amount received. Roth IRAs are also counted as part of your estate. However, beneficiaries will usually be able to avoid any income tax on the amounts received.
If the beneficiary is the spouse, the Roth IRA remains totally intact with the same rules and regulations as were previously in place. If the beneficiary is someone else, he or she must take distributions by the end of the fifth year after death occurs or over the period of his or her own life expectancy on a regular basis. In either case, income taxes can be totally avoided.
Coming up next: Which investments work best in IRAs.