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September-October, 2007 Tax Tip

Try to Avoid an Early Raid on Your IRA

 

In preparing the 2006 tax returns during the past (and still ongoing) filing season, there were a number of my clients who took early distributions from their IRA’s.  Whatever the reason was for dipping into their accounts, they were willing to take the consequences.

 

It is very important to remember that an IRA is a retirement account.  IRA’s were introduced into the tax law back in 1974 for the purpose of providing individuals a tax-favored way to put money aside for their retirement.   One of the proscriptions all along has been that, with a few exceptions, money cannot be withdrawn prior to age 591/2, without incurring significant penalties.

Therefore, unless absolutely necessary, your IRA should not be the place to look for needed money.

 

The cost of taking early withdrawal of funds from your IRA, in addition to taxing the withdrawn amount at ordinary tax rates, is a 10% penalty of the amount taken.  In addition, the amount withdrawn is no longer in the account earning tax-free buildup of additional money to fund retirement.  Talk about a double whammy – this is a triple whammy!

 

As mentioned, there are some exceptions to the imposition of the 10% penalty (but not to the inclusion in income).  The penalty is not imposed if the early distribution is due to death, disability, or for medical expenses that exceed 71/2% of AGI, whether or not the individual itemizes deductions.   Nor is the penalty imposed if the money is used to fund higher education expenses, first-time home purchases (limited to $10,000 over a lifetime), and health insurance payments by unemployed individuals.  For this purpose a first time homebuyer is an individual who has not owned a principal residence for at least two years.

 

A final exception worth noting applies to IRA owners who withdraw money as part of a series of substantially equal periodic payments (made at least annually) based on the individual’s life expectancy or the joint life expectancy of the individual and designated beneficiary.  Due to federal investigation of some questionable promoter schemes aimed at using this exception to get around the spirit of the law, it is recommended that it be used only to satisfy a specific need for which there is no satisfactory alternative.



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