Structuring IRA Distributions To Prevent Penalties - Protected Harbor Planning: A Few Effective Methods
IRA distribution rules are a mine field. One wrong move and you can find yourself faced with high taxes and penalties that could wipe out years of savings and investment. Complicating issues is the Darwinian evolution of IRAs that have taken place since the pioneer IRA was introduced in 1974 with the enactment of the Worker Retirement Income Security Act (ERISA ). Since 1974, IRA rules have changed dramatically and laws was enacted to rigorously punish those who do not follow the regulations, to the letter of the law. IRAs come in a lot of flavors but, for reasons of this article we will focus on the two main forms of IRAs: Traditional IRAs and Roth IRAs.
Methods for Minimizing Penalties on Early Distributions
Generally, any distribution from an IRA before you reach age 59 1/2 is considered as an early distribution and is subject to a ten percent penalty on the taxable quantity received in a distribution. There are specific IRA distribution rules that can be used to avoid the burden of this early withdrawal penalty.
1. Using IRA Funds to Buy or Construct Your First Home - Up to $10,000 might be withdrawn from an IRA as an early distribution penalty-free, as long as the distribution is used to buy, build or reconstruct a first house for yourself, your spouse, you or your spouse's kid, you or your spouse's grandchild or you or your spouse's parent or ancestor.
2. Using IRA Money for Medicinal Costs - Penalty-free early distributions can be made if the funds are used to pay unreimbursed medicinal costs which exceed 7.5 percent of your adjusted total income. There is no condition to itemize deductions in order to qualify for this exception.
3. Using IRA Money for Academy Expenses - Traditional IRAs can be also tapped to help fund college expenses; however, the taxable amount of the distributions from these IRAs will be subject to income tax in the year of the distribution.
Roth IRA distribution rules
Roth IRAs have unique rules with respect to distributions. Contributions withdrawn aren't matter of the ten percent penalty and there's no RMD with Roth IRAs. In order for Roth IRA earnings distributions to be tax-free, the account must have been opened for 5 years and the distributions must be made after reaching age 59 1/2. If you meet the five-year rule but not the 59 1/2 year regulation, distributions in excess of your contributions might be taxable and subject to a 10% penalty.
1. No RMD - With Roth IRAs, there is no RMD at age 70 1/2. This means a Roth IRA owner is never needed to make a distribution out of their Roth IRA. As a result, Roth IRAs can grow, untaxed, during the lifetime of the owner, permitting a larger legacy for their beneficiaries.
2. 0% Effective Tax Rate - Qualified distributions from Roth IRAs aren't subject to income tax...ever. This means you're unaffected by future tax increases as your effective tax rate is always the same...zero.
3. Conversion Opportunities - Beginning after January 1, 2010 anybody, irrespective of their income level, may convert traditional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be deferred into 2011 and 2012. If you don't have sufficient money set aside to do a 100% conversion you can do partial conversions.
4. College Expenses - Because Roth IRA contributions may be withdrawn, tax-free, penalty-free, at any time, this kind of contributions can be a tax-free future funding source for your child's school expenses.
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