Structuring IRA Distributions To Prevent Penalties - Safe Harbor Planning: A Few Useful Techniques

IRA distribution rules are a mine field. One incorrect move and you can find yourself faced with high taxes and penalties that can wipe out years of savings and investment. Complicating matters is the Darwinian evolution of IRAs that have taken place since the pioneer IRA was introduced in '74 with the enactment of the Worker Retirement Income Security Act (ERISA ). Since '74, IRA rules have changed dramatically and legislation was enacted to severely punish those who do not follow the policy, to the letter of the law. IRAs come in several flavors but, for reasons of this article we'll focus on the two main types of IRAs: Traditional IRAs and Roth IRAs.

Strategies for Minimizing Penalties on Early Distributions

Generally, any distribution from an IRA before you reach age 59 1/2 is considered as an early distribution and is subject to a 10 percent penalty on the taxable quantity received in a distribution. There're specific IRA distribution rules that can be used to avoid the imposition of this early withdrawal penalty.

1. Using IRA Money to Buy or Construct Your First Home - As much as $10,000 might be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to buy, build or rebuild a first home for yourself, your spouse, you or your spouse's kid, you or your spouse's grandchild or you or your spouse's parent or ancestor.

2. Using IRA Funds for Medicinal Costs - Penalty-free early distributions can be made if the funds are used to pay unreimbursed medical expenses which exceed 7.5 percent of your adjusted total income. There's no obligation to itemize deductions to qualify for this exception.

3. Using IRA Money for College Costs - Traditional IRAs can be also tapped to help fund university expenses; however, the taxable amount of the distributions from these IRAs shall be subject to income tax in the year of the distribution.

Roth IRA distribution rules

Roth IRAs have unique rules with respect to distributions. Contributions withdrawn are not subject to the ten percent penalty and there's no RMD with Roth IRAs. In order for Roth IRA earnings distributions to be tax-free, the account should have been opened for 5 years and the distributions should be made after reaching age 59 1/2. If you meet the five-year rule but not the 59 1/2 year rule, distributions in excess of your contributions will be taxable and subject to a 10% penalty.

1. No RMD - With Roth IRAs, there is no RMD at age 70 1/2. This means a Roth IRA operator is never needed to make a distribution out of their Roth IRA. Because of this, Roth IRAs can grow, untaxed, during the lifetime of the owner, permitting a larger legacy for their beneficiaries.

2. Zero Percent Effective Tax Rate - Qualified distributions from Roth IRAs are not subject to income tax...ever. This means you're unaffected by future tax increases as your effective tax rate is always the same...zero.

3. Conversion Possibilities - Beginning after January 1, 2010 anybody, irrespective of their earnings level, may convert traditional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be deferred into 2011 and 2012. If you do not have enough money set aside to do a 100% conversion you can do partial conversions.

4. College Expenses - Because Roth IRA contributions might be withdrawn, tax-free, penalty-free, at any time, this kind of contributions can be a tax-free future funding source for your child's university expenses.

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