Distributions from Traditional IRAs: Prior to Age 59½

In general

A withdrawal from an IRA is generally referred to as a distribution. If you receive a distribution from your traditional IRA before you reach the age of 59½, the federal government considers this a premature distribution.

Like all distributions from traditional IRAs, premature distributions are generally taxable. You will pay federal (and possibly state) income tax on the portion of the distribution that represents tax-deductible contributions, any pre-tax funds that were rolled over into the IRA from an employer-sponsored retirement plan, and investment earnings.

In addition to regular income tax, distributions taken prior to age 59½ may be subject to a 10% federal penalty tax (and possibly a state penalty) on the taxable portion of the distribution. You can avoid this federal penalty (known as the premature distribution tax) only if you are age 59½ or older at the time of the distribution, or if you meet one of the exceptions allowed by the IRS (see below).

You’re probably wondering why your age at the time of distribution should matter and possibly result in a penalty on the distribution. The purpose of IRAs and retirement plans is to provide income to help fund your retirement years, and the federal government wants to make sure you use the money for that purpose. To accomplish this goal, the government imposes a penalty tax on taxable distributions taken before age 59½.

The penalty tax encourages you (and other IRA owners and plan participants) to leave your money in the IRA or plan until that age or later. This, in turn, reduces the risk that you will deplete your funds prematurely and run out of money at some point in retirement. The assumption is that by the time you reach age 59½, you are either already retired or near retirement and can safely begin using your retirement money.

Caution: This discussion pertains primarily to distributions from traditional IRAs. Qualified distributions from Roth IRAs are tax-free. Even Roth IRA distributions that don’t qualify for tax-free treatment are tax free to the extent of your own contributions to the Roth IRA.

Only after you’ve recovered all of your contributions are distributions considered to consist of taxable earnings.  Further, special rules apply to distributions taken from Roth IRAs that have funds rolled over or converted from traditional IRAs.

Caution: This article applies to distributions to IRA owners. Special rules apply to distributions to IRA beneficiaries.

Caution: Special rules apply to distributions to qualified individuals impacted by certain natural disasters and to qualified reservist distributions.

Example showing the effect of taxes and penalties

Income taxes on IRA and retirement plan distributions can really add up. When a distribution is also subject to the 10% federal penalty, the portion of the distribution that goes into your pocket obviously dwindles even further. To illustrate the possible effect of taking a distribution before age 59½, consider the following scenario.

Example(s): Joe retired on his 59th birthday. On that day, he withdrew the entire balance in his traditional IRA valued at $100,000. The entire distribution was taxable. Because Joe also had considerable income from working that year, the IRA distribution was taxed in the maximum 37% federal income tax bracket. That came to $37,000 in federal income tax (assuming no other variables).

Joe was in the 9.3 percent state income tax bracket, so that meant another $9,300 in state income tax. Since Joe was under age 59½ and no exception to the premature distribution tax applied to him, he had to pay $10,000 in federal penalties (the 10% federal penalty tax), plus another $2,500 in state penalties (due to a 2.5% state penalty). He ended up paying $58,800 in taxes and penalties, leaving only $41,200 for his own use.

Example(s): If Joe had waited until he was 59½ or older to take his distribution, he would have avoided the federal and state penalties and saved $12,500. Also, if he had waited two months until the next year (when he had no taxable income from working), the distribution might have been taxed in a lower income tax bracket. It would definitely have paid for Joe to get tax advice before taking that distribution from his traditional IRA.

Example(s): Of course, if Joe had ever made any nondeductible contributions to his traditional IRA, the portion of his distribution that represented nondeductible contributions would not have been taxable because those contributions had already been subject to tax. That portion of his distribution would not have been subject to the 10% federal penalty either, since the penalty applies only to the taxable portion of a premature distribution.

If you are close to age 59½ and wish to take a distribution from your traditional IRA, check the calendar carefully to avoid a potentially costly mistake.

Exceptions to the premature distribution tax

Remember, only the taxable portion of a premature distribution is subject to the 10% federal penalty. This means that if you ever made any nondeductible (after-tax) contributions to your traditional IRA, a portion of your distribution may not be subject to tax or penalty.

In addition, the IRS grants certain exceptions to the 10% federal penalty on distributions taken before age 59½. Premature distributions taken from a traditional IRA under the following circumstances will not be subject to the penalty:

• Your beneficiary (or estate) is receiving the funds after your death, regardless of your beneficiary’s age or your age at the time of your death
• You are receiving the funds due to your qualifying disability (IRS definition of disability must be met)
• You are taking the distributions under one of the three annuity formulas approved by the IRS (often referred to as substantially equal periodic payments)
• You are paying unreimbursed medical expenses in excess of 7.5% of your adjusted gross income (AGI) for the year
• You are paying health insurance premiums for you, your spouse, or your dependents during a year in which you collected unemployment benefits for more than 12 consecutive weeks
• You make a qualifying, nontaxable rollover (or direct transfer)
• You are using the funds for the qualified higher education expenses of yourself, your spouse, your children, your spouse’s children, your grandchildren, or your spouse’s grandchildren
• You are using the funds to pay the first-time homebuyer expenses of yourself, your spouse, your children, your grandchildren, or an ancestor of your spouse or you ($10,000 lifetime limit)
• The IRS is levying on your IRA to cover your unpaid federal income tax liability
• Your distribution is a qualified reservist distribution

How do you pay the premature distribution tax?

The 10% federal penalty on premature distributions is reported and paid on your federal income tax return for the year in which you received the distribution. You must complete and attach Form 5329, titled Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts. If you receive a premature distribution but qualify for one of the exceptions described above, see Form 5329 for instructions.

Should you take distributions from your traditional IRA before age 59½?

You are allowed to take distributions from your traditional IRA whenever you like and in any amount you choose. That does not mean, however, that you should take distributions. As a general rule, it is not advisable to take distributions from a traditional IRA before age 59½ (or for that matter, at any age prior to your retirement).

First, as illustrated above, the portion of the distribution that goes to the federal government for taxes can be substantial — not to mention state taxes and penalties. This is especially true if the entire distribution will be taxable, and if none of the exceptions to the premature distribution tax apply to you.

In addition, even if all or some of the distribution will not be taxed or penalized, taking IRA distributions before age 59½ is still generally not wise. By dipping into your IRA funds at a relatively young age, you run the risk of depleting those funds sooner than you had anticipated.

This could jeopardize your retirement goals and financial security later in life. Funds removed from an IRA may also be missing out on several years or more of potential tax-deferred growth, depending on investment performance.

However, the decision of whether to tap into your IRA nest egg ultimately depends on your individual circumstances. Perhaps you have urgent expenses, and withdrawing from your IRA is the only way you can pay them. It is also possible that you have accumulated large balances in your IRAs and other retirement accounts, so that withdrawing from your IRAs now will not pose a risk to your future financial security. In these cases, taking distributions before age 59½ is not necessarily ill-advised. Whatever your situation, though, you should consult a tax professional before taking a distribution.

IRA rollovers and transfers

In general

In general, there are two ways to transfer assets between IRAs —  indirect rollovers and trustee-to-trustee transfers (also known as “direct rollovers”). With an indirect rollover, you receive funds from the distributing IRA and then complete the rollover by depositing the funds into the receiving IRA within 60 days.

A trustee-to-trustee transfer is a transaction directly between IRA trustees and custodians. If properly completed, rollovers and trustee-to-trustee transfers are not subject to income tax or the 10% premature distribution tax.

Tip: You are still allowed to make your regular IRA contribution in a year when you have a rollover or trustee-to-trustee transfer.

Tip: You can roll over (or transfer) funds from a traditional IRA to another traditional IRA or from a Roth IRA to another Roth IRA. Special rules apply to converting or rolling over funds from a traditional IRA to a Roth IRA. You may also be able to roll over (or transfer) taxable funds from an IRA to an employer-sponsored retirement plan.

60-day rollover: you receive the funds and reinvest them

With an indirect rollover, you receive a distribution from your IRA and then, to complete the rollover, you deposit all or part of the amount distributed into the receiving IRA within 60 days of the date the funds are released from the distributing account.

Example(s): On January 2, you withdraw your IRA funds from a maturing bank CD and choose to have no income tax withheld. The bank cuts a check payable to you for the full balance of the account. You plan to move the money into an IRA account at a competing bank. Fifteen days later, you go to the new bank and deposit the full amount of your IRA distribution into your new rollover IRA CD. Your rollover is complete.

If you don’t complete the rollover transaction or miss the 60-day deadline, your distribution is taxable to you. However, there are several ways to seek waiver of the 60-day deadline, including an automatic waiver in some cases, self-certification if you missed the deadline due to one of eleven specified reasons, or by seeking a private letter ruling from the IRS.

Example(s): Assume the same scenario as the first example, except that when you receive your check from the first bank, you cash the check and loan the money to your brother-in-law, who promises to repay you in 30 days. As it turns out, he doesn’t pay back the loan until March 5 (the 62nd day after your withdrawal).

You deposit the full sum into the IRA account at the new bank. However, because you didn’t complete your rollover within the 60-day time period, the January 2 distribution will be taxable (excluding any nondeductible contributions, as described above).

Caution: Under recent IRS guidance, you can make only one tax-free, 60 day, rollover from one IRA to another IRA in any one-year period no matter how many IRAs (traditional, Roth, SEP, and SIMPLE) you own. This does not apply to direct rollovers (trustee-to-trustee transfers), or Roth IRA conversions.

If you roll over part, but not all, of your distribution within the 60-day period, then only the portion not rolled over is treated as a taxable distribution.

When you take a distribution from your traditional IRA, your IRA trustee or custodian will generally withhold 10% for federal income tax (and possibly additional amounts for state tax and penalties) unless you instruct them not to. If tax is withheld and you then wish to roll over the distribution, you have to make up the amount withheld out of your own pocket.

Otherwise, the rollover is not considered complete, and the shortfall is treated as a taxable distribution. The best way to avoid this outcome is to instruct your IRA trustee or custodian not to withhold any tax. Unlike distributions from qualified plans, IRA distributions are not subject to a mandatory withholding requirement.

Example(s): You take a $1,000 distribution (all of which would be taxable) from your traditional IRA that you want to roll over into a new IRA. One hundred dollars is withheld for federal income taxes, so you actually receive only $900.

If you roll over only the $900, you are treated as having received a $100 taxable distribution. To roll over the entire $1,000, you will have to deposit in the new IRA the $900 that you actually received, plus an additional $100. (The $100 withheld will be claimed as part of your credit for federal income tax withheld on your federal income tax return.)

Trustee-to-trustee transfer

A trustee-to-trustee transfer (also known as a “direct” rollover) occurs directly between the trustee or custodian of your old IRA and the trustee or custodian of your new IRA. You never actually receive the funds or have control of them, so a trustee-to-trustee transfer is not treated as a distribution (and therefore the issue of tax withholding does not apply). Further, trustee-to-trustee transfers are not subject to the 60-day deadline, or the “once-per-12-month” limitation.

Example(s): You have an IRA invested in a bank CD with a maturity date of January 2. In December, you provide your bank with instructions to close your CD on the maturity date and transfer the funds to another bank that is paying a higher CD rate. On January 2, your bank issues a check payable to the new bank (as trustee for your IRA) and sends it to the new bank. The new bank deposits the IRA check into your new CD account, and your trustee-to-trustee transfer is complete.

Trustee-to-trustee transfers avoid the danger of missing the 60-day deadline, and are generally the safest, most efficient way to move IRA funds. Taking a distribution yourself and rolling it over only makes sense if you need to use the funds temporarily, and are certain you can roll over the full amount within 60 days.

Converting or rolling over traditional IRAs to Roth IRAs

Have you done a comparison and decided that a Roth IRA is a better savings tool for you than a traditional IRA? If so, you may be able to convert or roll over an existing traditional IRA to a Roth IRA. However, be aware that you will have to pay income tax on all or part of the traditional IRA funds that you move to a Roth IRA.

It is important to weigh these tax consequences against the perceived advantages of the Roth IRA. This is a complicated decision, so it may make sense to seek professional assistance.

Tip: When you convert or roll over a traditional IRA to a Roth IRA prior to age 59½, the taxable portion of the funds is not subject to the premature distribution tax. However, special rules may apply if you make a nonqualified withdrawal from the Roth IRA within five years of the conversion or rollover. For more information, consult a tax advisor.

 

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

This blog is provided by Windward Private Wealth Management Inc. (“Windward” or the “Firm”) for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this blog is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in the individual blog posts will be derived from sources that Windward believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.

Windward is an SEC registered investment adviser. The Firm may only provide services in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about Windward’ registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.