We usually don’t advise you to begin taking early withdrawals from your qualified retirement plans and IRAs. Not only does this erode the nest egg you’ve diligently built for retirement, you typically will also be hit with a 10% premature withdrawal penalty tax on top of the regular income you will owe if you take withdrawals before age 59½.
But you may be facing a cash crunch during this recession with no other alternative.
Strategy: Minimize the tax damage. If you qualify under one of the special tax law exceptions, you don’t have to pay the usual 10% penalty—even if you’re nowhere close to 59½ years old. (Regular income tax still applies.)
The rules differ slightly for qualified plans and IRAs, but here are five ways to get your hands on the cash.
1. Take separate but equal payments
No penalty will be assessed if you arrange to receive “substantially equal periodic payments” (SEPPs) from a qualified plan or IRA based on your life expectancy or the joint life expectancies of you and a designated beneficiary. The payments must last for the longer of five years or until you reach age 59½. You must receive at least one SEPP a year, and the annual payment amounts generally can’t be modified.
The IRS allows three methods for computing SEPPs under the IRS life expectancy tables. Consult with your tax pro for the best method for your situation.
2. Find the cure for medical woes
If your family has been hit with some unexpected medical bills, you can tap into your IRA to pay for medical expenses. The withdrawals are exempt from the penalty to the extent that the cost qualifies for the itemized medical expense deduction (i.e., unreimbursed medical expenses above 7.5% of your adjusted gross income, or AGI).
For example, suppose you have an annual AGI of $100,000 and you incur $10,000 in medical expenses for surgery that isn’t covered by health insurance. You can withdraw up to $2,500 from your IRA ($10,000 less 7.5% of your AGI) without incurring the 10% early withdrawal penalty.
3. Answer when opportunity knocks
The tax law includes a special tax break for first-time homebuyers. You don’t have to pay the penalty on pre-age 59½ withdrawals if you take out money to buy or build a principal residence and you have not owned a home during the two years before the purchase date.
Similarly, you might use the IRA funds to help your child buy a home. The exception also applies to your offspring as long as the home is your child’s primary residence and he or she hasn’t owned a home within two years. Caution: There’s a lifetime dollar cap of $10,000 on this particular exception whether you use it for yourself or for a child.
4. Get a passing tax grade
Do you need to invade your IRA to help pay for your children’s college expenses? If so, don’t worry about the 10% penalty tax. Distributions made before age 59½ won’t trigger the penalty if the funds are used to pay for qualified education expenses. This includes tuition, books, supplies, etc.—even room and board if your child is a full-time student.
Furthermore, this tax break isn’t limited to your children. It’s also available for expenses paid on behalf of yourself, your spouse or any grandchildren.
5. Keep health insurance intact
If an employee is laid off or fired from the job, he or she may extend health insurance coverage under COBRA. If IRA funds are used to pay for coverage, early withdrawals are exempt from the penalty.
But suppose you’re self-employed. In a new field advice memo, the IRS says self-employeds are exempt, too, if they can show they would have received unemployment benefits for 12 weeks if they were an employee. (IRS Chief Counsel Advice 200920052)
Tip: Continue to view early withdrawals as a last resort. If it’s an absolute necessity, choose carefully.
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