Simply Junior

I have received e-mail after e-mail asking about penalties for early withdrawals from IRAs or other retirement plans. When the economy is good and account values are high, I never hear it which tells me not only are things tight for the average retiree, they are tight for everybody. In some cases families spent their way into a short fall. Some others may have lost their jobs. Whatever the case, you should know the rules and penalties before you tap your retirement savings.

Penalties for Early Withdrawals of IRAs or Qualified Retirement Plans

Given the difficult times, some taxpayers may be tempted to apply for early withdrawals of funds from retirement plans to alleviate financial hardship. In addition to taxing the withdrawals, the IRS also assesses a 10% penalty on such taxable withdrawals, making this an expensive source of funding. Additionally, if the withdrawal is coming from a SIMPLE Plan, and the taxpayer first started contributing to the plan within two years, the early withdrawal penalty is 25%.

There are exceptions to the early withdrawal penalty rules that a taxpayer may wish to consider. For some early withdrawals from retirement plans, these may include using the funds for a rollover (either a direct rollover or within 60 days of having received the funds), paying for health insurance premiums if unemployed, paying for education expenses for either the taxpayer or a dependent, paying for medical expenses in excess of 7.5% of adjusted gross income, purchasing a home (if the taxpayer did not own a home within two years and limited as to how much of the distribution qualifies to avoid the penalty), if permanently or totally disabled or if the IRS has levied the taxpayer’s retirement account to pay off tax debt.

Substantially Equal Periodic Payments

One important exception to the penalty rules on early withdrawals include substantially equal periodic payments (also called SEPP or 72t, named for the tax code that permits the exception). In order to qualify for the exception, the period must be for a minimum of five years or until the taxpayer is 59

After you leave a job, there is a big tax question you will have to deal with and that is what should you do with any money you have in a qualified retirement plan with that former employer. This included the 401(k), stock bonus, profit-sharing and any other qualifying plan. Generally you would be advised to roll it all into an IRA.

While this usually makes a lot of sense, it allows you to take management of your funds for retirement and continue deferring taxes on income the funds generate. Be aware though, if this process is not handled correctly the rollover can end up being very costly. Let us take a look at the property way your should arrange your rollover tax-free.

Roll over directly (trustee to trustee)

If the decision to rollover is what you made, make sure you plan for a trustee-to-trustee or direct rollover from your retirement account into a rollover IRA. Don’t have the check written to you personally, make the check you receive from your company’s plan out to the trustee or the custodian of your new rollover IRA. You can even have a wire transfer made into your new IRA rollover account.) Since the new IRA has to be set up before you receive the rollover, your IRA account can remain empty until the rollover transaction is made.

The direct rollover is essentially important because if you get the check made payable to yourself there is a 20% taxable amount withheld for the federal income tax. Leaving you with sixty days to get the “missing” 20 percent and put it in the rollover IRA. And you will end up owing taxes on that 20%. And you will end up paying the dreaded ten percent early withdrawal tax as well if you are under 55.

If you are Over 55 you Should not Rollover Any of the Money You Need

Generally rollovers are good because they defer the taxes, but think about it this way… you are over 55 and you get a payout from the former employer’s retirement plan, you will not have to pay the premature 10% withdrawal tax if you keep the money (but you will still owe the income taxes). But if you roll that money into the IRA and then you need to take some out later, before the age of 59.5, you will have to pay a ten percent penalty tax on it.

Obeying the 60-Day Rule

This is another pitfall in the rollover, failure to meet their 60-day ruling. You will have to deposit the distribution into the new rollover IRA within the 60 day period in order to get the tax-free rollover. This 60-days will start the day after the funds are received from the company’s retirement account. And if the 60-day period ends on a holiday or weekend, you will not get any slack.

The Bottom Line Is

It might seem like a simple task, however arranging your tax-free rollover of your retirement account is not so simple. I have seen failed rollover attempts from people many years now and there is no end in sight. Ask the advice of a tax pro to clarify anything you don’t understand that we went over in this article.