Are You Considering Taking an Early IRA Distribution?

Our economy is slowly rebounding, according to the forecasts of most financial analysts. However, out of the estimated 50 million individuals in the United States who hold self-directed retirement accounts, we can be sure that many have taken an early withdrawal.

Some may have dipped in and extracted a small amount while others may have sacked the account in full to ease economic struggles.

If so, the IRS wants you to be aware of the tax consequences of taking an early withdrawal from your IRA. What is an early withdrawal? Is there a penalty for pulling out funds before they are vested? Does the IRS allow for any exceptions for accessing funds early?

Early Withdrawal

Generally, distributions that an individual takes from his or her IRA or other qualified retirement plan prior to reaching age 59½ are considered "early" for tax purposes.

In most cases, an IRA cannot be borrowed from, unlike borrowing provisions associated with 401 plans established through your employer. However, you may be able to take something called an indirect rollover. More on that in a moment.

If you take an early withdrawal, in addition to paying tax on the amount that was withdrawn, you may have to pay a 10% early withdrawal penalty.

The IRS does allow for certain exceptions. An individual may be exempted from having to pay the 10% penalty if one of the following applies:
* The distribution came from a retirement plan other than an IRA, and the individual is at least age 55 after leaving their employment.

* An individual's unreimbursed medical expenses exceed 7.5% of their Adjusted Gross Income as determined on their tax return. This is also the same percentage that allows taxpayers to deduct medical expenses on their Schedule A.

* The funds are used for qualifying educational purposes, or to buy or build a first home (limited to a $10,000 maximum distribution).

* The distribution is due to an IRS levy. This does not mean you can coerce the IRS into issuing a levy on your IRA for the purpose of avoiding the penalty.

The 10% tax is generally reported directly to the appropriate line of Form 1040. For 2010 tax returns, report the 10% tax on 1040 Line 58. You may also need to file Form 5329, Additional Taxes on Qualified Plans.

For additional exceptions to the 10% rule, see the link for Publication 590 at the end of the article.

Rollovers

Distributions are rolled over, or transferred from one account to another, when funds are withdrawn from a qualified retirement plan, such as a 401 plan, and deposited into a Traditional IRA or another qualified retirement plan.

The 10% tax is held in abeyance with a qualified rollover. You have a 60-day window from the date the retirement plan distribution is received to roll it over.

There are tax benefits with most traditional IRAs. Income taxes generally do not have to be paid when contributions are made into the IRA. Once you begin taking withdrawals, then the tax becomes accountable. But because this is typically after you retire, you may be in a lower tax bracket and thus responsible to pay less tax.

There are additional tax advantages with a Roth IRA. For more information on Roth IRA products, see the Roth Comparison Chart on the IRS web site.

If you need a quick cash infusion, and you know that you will have the funds available to redeposit into the IRA within 60 days, you may consider an indirect rollover. Essentially, you are borrowing your own money and paying yourself back, interest free.

This is considered a non-taxable rollover, and the IRS allows this once every 12 months. The 12 month waiting period begins the day you physically receive the paper check, not the day you redeposit your funds back into the IRA.

For more information, see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements.

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