Structuring IRA Distributions To Avoid Penalties - Protected Harbor Planning: Several Helpful Techniques

IRA distribution rules are a mine field. One wrong move and you can find yourself faced with high taxes and penalties which could wipe out years of savings and investment. Complicating matters is the Darwinian evolution of IRAs that have taken place since the first IRA was introduced in '74 with the enactment of the Employee Retirement Income Security Act (ERISA ). Since 1974, IRA rules have changed dramatically and laws 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 purposes of this article we will focus on the two major forms of IRAs: Traditional IRAs and Roth IRAs.

Techniques for Minimizing Penalties on Early Distributions

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

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 Using IRA Money to Buy or Build Your First Home - As much as $10,000 may be withdrawn from an IRA as an early distribution penalty-free, as long as the distribution is used to buy, build or reconstruct a first home for yourself, your spouse, you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

2. Using IRA Funds for Medical Expenses - Penalty-free early distributions can be made if the funds are used to pay unreimbursed medicinal costs which exceed 7.5 percent of your adjusted gross income. There's no obligation to itemize deductions in order to qualify for this exception.

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

Roth IRA distribution rules

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 Contributions withdrawn aren't subject to the ten percent penalty and there is no RMD with Roth IRAs.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

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

2. 0% Effective Tax Rate - Qualified distributions from Roth IRAs are not subject to income tax...ever. This means you are unaffected by future tax increases as your effective tax rate is always the same...zero.

3. Conversion Chances - Beginning after January 1, 2010 anyone, irrespective of their income 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 don't have enough money set aside to do a 100% conversion you can do partial conversions.

4. College Costs - Because Roth IRA contributions might be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child's college expenses.

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Individual Retirement Accounts (IRAs) distribution rules are a mine field. One wrong move and you can find yourself faced with high taxes and penalties that can wipe out years of savings and investment.

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