Learn These IRA Rules to Avoid Costly Penalties - Rodgers & Associates

Learn These IRA Rules to Avoid Costly Penalties

IRAs have some quirky rules. There is a penalty for withdrawing money from an IRA before age 59 ½, for example, but excep­tions exist. There is a requirement to begin taking money from an IRA account at age 73, but again, excep­tions exist. There’s rarely a week I don’t get a question about some confusing IRA rule. Let’s take a look at a few of the commonly misun­der­stood rules.

The early withdrawal rule

One of the tricky aspects of this rule—that IRA account owners must reach age 59 ½ to withdraw money penalty-free—is the age itself. Why a half year and how do you count it? Take an accoun­tholder whose birthday is June 1 as an example. This person would turn 59 ½ on December 1, which means any withdrawals up until November 30 would be subject to a 10% penalty. Fortu­nately, you don’t have to worry about counting days; you’re considered 59 ½ when you reach the same calendar day of your birthday in the six month after your birthday (1 in the above example).

The 59 ½ rule only applies to IRAs and not to employer-sponsored plans like 401(k)s or 403(b)s. Withdrawals from an employer plan are penalty-free in the year the plan partic­ipant turns age 55. This means a plan partic­ipant who turns age 55 on December 1 can take a penalty-free withdrawal from their 401(k) starting on January 1 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 that this rule doesn’t apply to in-service withdrawals.)

The RMD rule

This rule requires IRA owners to take their first required minimum distri­b­ution (RMD) by April 1 following the date they turn 73. Someone who turns 73 during 2023, for example, must take their first RMD by April 1, 2024. The twist on this rule is that if this person waited until the first quarter of 2024 to take their first distri­b­ution, their second distri­b­ution would be due by December 31, 2024. They may not want to take two distri­b­u­tions in the same tax year for tax planning purposes.

The QCD rule

Qualified Chari­table Distri­b­u­tions (QCDs) are permitted only after the IRA owner has reached the age of 70 ½. (The QCD age was not raised when the Consol­i­dated Appro­pri­a­tions Act of 2023 changed the beginning age for RMDs to 73.) QCDs are direct distri­b­u­tions to a qualified charity, and the amount given is counted towards the RMD once the IRA owner turns 73. QCDs are attractive because they aren’t included in the taxpayer’s adjusted gross income (AGI). If an IRA owner makes the distri­b­ution before they’ve turned 70 ½, however, the distri­b­ution will be included in their AGI, and the deduction can be taken on Schedule A if the taxpayer itemizes deductions.

The 60-day rollover rule

Some people call this rule the 60-day IRA loan provision, and it also has a quirky calendar clause. The rule states that the accoun­tholder can take money out of their IRA tax- and penalty-free as long as it is returned within 60 days. You cannot borrow against an IRA, however. IRA owners can use this provision once per year, but it doesn’t follow the calendar year. The owner must wait 365 days from the day the first distri­b­ution was received before doing another 60-day rollover.

The five-year rule

Here’s another tricky one: 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. This rule also applies to tradi­tional IRAs. For tax purposes, the five-year timeline begins on January 1 of the year the first contri­bution was made. For example: For a Roth IRA that was first funded on April 1 for the tax year 2022, the five-year clock begins on January 1, 2022. The best part of this rule is that you only need one Roth IRA to start the five years, no matter how many other Roth IRAs you open in the future.

The five-year rule is different for 72(t) distri­b­u­tions. These penalty-free early withdrawals from IRAs must be taken 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 have passed, whichever is longer. The age 59 ½ part of the rule is based on attained age like before, and the five-year requirement starts when the first distri­b­ution is made. Therefore, you need to make at least 60 monthly (or five annual) distri­b­u­tions and attain the age of 59 ½ to meet all the requirements.

It’s easy to run afoul of these IRA rules, and penalties can be stiff. There is a 25% tax penalty for failing to take an RMD. If not appro­pri­ately handled, all 72(t) distri­b­u­tions are considered taxable and subject to penalty. Similarly, if the 60-day rollover rule isn’t appro­pri­ately handled, excess contri­bution penalties could be levied. Sometimes, it’s as simple as knowing which date to use and counting the clock. Consult a knowl­edgeable financial adviser to be sure you get the timing right.

Rick’s Insights

  • 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, and 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.

Origi­nally Posted: April 3, 2013