IRAs have some quirky rules. There is a penalty for withdrawing money from IRA before age 59 ½ but there are exceptions. You must begin taking money from your IRA at age 70 ½ but there are exceptions. There is rarely a week that goes by when I’m not asked a question about some IRA rule that has been misunderstood.
One of the quirky aspects of the early withdrawal rule is the owner must attain age 59 ½ before accessing their IRA money penalty free. For example, an IRA owner’s birthday is June 1st. This person turns 59 ½ on December 1st. Any withdrawals during the year up until November 30th would be subject to the 10% penalty. Fortunately you don’t have to worry about counting days. You are considered to be 59 ½ when you reach the sixth month after your birthday on the same calendar day. February won’t trip you up.
The age 59 ½ rule only applies to IRAs but not to company plans. Withdrawals from a company plan like a 401(k) or 403(b) are penalty free in the year the plan participant turns age 55. This means a plan participant who turns age 55 on December 1st can take a penalty free withdrawal from their 401(k) on January 1st of that year. Since they will attain the age of 55 in the year of the withdrawal, the distribution is not subject to penalty. Note this rule does not apply to in-service withdrawals.
The rule for required minimum distributions (RMD) requires the first distribution to be taken by April 1st of the year following the year the IRA owner reaches age 70 ½. The person whose 70th birthday is on July 1, 2013 turns 70 ½ on January 1, 2014 and must take their first RMD by April 1, 2015. The twist on this rule is that if they waited until the first quarter of 2015 to take the first distribution their second distribution would be due by December 31, 2015. For tax planning purposes they may not want to take two distributions in the same tax year.
Qualified Charitable Distributions (QCD) are permitted only after the IRA owner has attained the age of 70 ½. QCDs are direct distributions to a qualified charity. The provision was reinstated in the American Taxpayer Relief Act of 2012 but only until the end of 2013. Distributions made directly to a charity qualify as an RMD but aren’t included in the taxpayers adjusted gross income (AGI). If the IRA owner makes the distribution before they have attained age 70 ½, the distribution will be included as part of their AGI but the deduction can be taken on Schedule A.
The 60-day rollover rule also has a quirky calendar clause. Some people call it the 60-day IRA loan provision. The rule states you can take money out of your IRA tax and penalty free as long as you put it back within 60 days. You cannot borrow against your IRA. You can use this provision once per year but it is not based on the calendar year. You must wait 365 days from the day the first distribution was received before doing another 60-day rollover.
Distributions of earnings from a Roth IRA are only considered tax-free when the owner attains the age of 59 ½ and five full years have passed since the owner established their first Roth IRA. Attaining age 59 ½ is the same rule as mentioned above for traditional IRAs. The five-year timeline begins on January 1st of the year the first contribution was made for tax purposes. For example, if you open your first Roth IRA by making a contribution on April 1, 2013 for the tax year 2012, the five-year clock begins on January 1, 2012.
The best part of this rule is that you only need one Roth IRA to start the five-year period no matter how many other Roth IRAs are opened in the future.
The five-year rule for 72(t) distributions is different. One of the early withdrawal penalty exemptions for IRAs is when you take distributions in substantially equal periodic payments. The rule requires IRA owners younger than age 59 ½ to stick with the withdrawal schedule until they reach age 59 ½ or five years has passed, whichever is longer. The age 59 ½ part of the rule is based on attained age like before. The five-year requirement starts when the first distribution is made. Therefore you will need to make at least 60 monthly (or 5 annual) distributions and attain the age of 59 ½ to meet all the requirements.
It can be easy to run afoul of these quirky IRA rules and penalties can be stiff. There is a 50% tax penalty for failing to take an RMD. All 72(t) distributions will be considered taxable and subject to penalty if not handled properly. Excess contribution penalties could be levied if the 60-day rollover rule is mishandled. Sometimes it is as simple as knowing which date to use and how the clock is counted. Consult a knowledgeable financial adviser to be sure you get the timing right.
- The early withdrawal penalty applies to IRA distributions until you have attained the age of 59 ½.
- The 60-day rollover rule is not a 60-day loan. You cannot borrow from your IRA or pledge it as collateral.
- Roth IRA earnings distributions are not tax-free until you have attained age 59 ½ and your first IRA account has met the five-year rule.