Most IRA owners have had it drummed into their heads that serious consequences result if any money is withdrawn from this account before they turn 59½. (These can include a 10 percent penalty, as well as interest.)
However, if you know the rules, there are a half-dozen or so ways to access your IRA “early” and at least avoid the penalty. (Money withdrawn from a “traditional” IRA, that consists only of pre-tax contributions, will always be subject to income tax.)
Exceptions to the 10 percent “early withdrawal penalty” can be found in Section 72(t) of the Internal Revenue Code. They include becoming disabled, buying a first-time home, paying college expenses (for yourself, your spouse, your child, or grandchild), and purchasing health insurance after you’ve been unemployed for a period.
In addition, if you go through a divorce and the judge requires you to split your retirement savings with your ex, regardless of your age, you can transfer assets from your IRA to your ex-spouse’s. I won’t tell you it will be painless, but at least you won’t get hit with income tax plus a penalty on the amount that leaves your account.
Another exception is one that the IRA cannot personally use because, well, you have to die for it to apply. “Death of the IRA Owner” is, in fact, the first exception under Section 72(t). When the IRA owner is deceased, regardless of the beneficiary’s age, she or he can withdraw money from the inherited IRA without penalty. (Income tax may apply.)
Lastly, there’s the “substantially equal periodic payments” exception. If — for whatever reason — you need to tap your IRA before age 59½, you can avoid the 10 percent penalty provided you use one of the IRS-approved methods to calculate the amount. (Sorry, you don’t get to withdraw whatever you want.)
In addition, you must continue taking annual withdrawals until: a) 5 years have passed, or b) you reach age 59½, whichever takes longer.
Numerous rulings by the I.R.S. have made it very clear that they are not going to cut you any slack if you make a mistake under this last exception to the early withdrawal rule. If you do, not only will you get retroactively hit with penalties, you will also have to pay interest.
First, if you’re withdrawing money from your IRA under the “substantially equal periodic payments” (SEPP) exception, it’s critical that you don’t do anything else that affects the balance in the IRA.
“Any transfer in or out of the account is an impermissible modification,” according to CPA Barry Picker, of the firm Picker, Weinberg, & Auerbach in Brooklyn, N.Y.
For instance, say you started taking SEPPs in 2005 when you were 56 years old. Although you’d be 59½ three and a half years later, according to the rules, you cannot stop your withdrawals until you reach age 61 (because 5 years is the longer period) — no problem there.
However, in April of this year you made your 2006 IRA contribution, sending $4,000 to this same IRA.
You’ve just committed a fatal error by “modifying” the balance in your IRA. If the IRS catches this, you will lose the privilege of penalty-free withdrawals going back to the first one you took. You’ll have to pay the 10 percent penalty — plus interest — on every cent you’ve taken out since Day No. 1.
Even if you’re scrupulous about not altering the IRA from which you’re receiving SEPPs, you can still get in trouble due to actions by a third party. One poor guy in the midst of a SEPP program got slapped with penalties and interest when his former employer sent a late 401(k) contribution to his rollover IRA after he’d retired.
He had no idea he was going to receive this money. None-the-less, his claims that he was an innocent victim fell on deaf ears.
In another case, an individual started taking SEPPs on January 21st. He continued withdrawing the required amount in each of the next 4 years, as required. His last withdrawal was on October 1st.
Thinking he had followed the letter of the law, he authorized his company to roll his employer-sponsored retirement plan into this IRA. The money was deposited on October 22 -- i.e. three weeks after he took his fifth and final withdrawal.
Even though he had taken the number of payments required, technically the 5-year period had not yet been reached. The I.R.S. pointed out that the 5-year period was not up until January 20th of the following year (Year 6).
The premature addition to this IRA was ruled a “modification” of his SEPP. He, too, was retroactively hit with penalties and interest.
In a recent case, an individual who was taking SEPPs from his IRA transferred part of the balance to another IRA with a different custodian. In the midst of this he transferred a portion of the account balance.
“If he had moved the whole thing that would have been OK,” says Picker. “However, because he split the pie into two pieces, the I.R.S. claimed that was a modification.”
The lesson: Yes, there are ways to access the money in your IRA before age 59½ and avoid a penalty. But you have to be very, very careful if you choose the “substantially equal periodic payments” method. Be sure the amounts you withdraw are calculated correctly and that you strictly follow the I.R.S. timetable.
Hope this helps,
If you have a question for Gail Buckner and the Your $ Matters column, send them to: email@example.com, along with your name and phone number.