Avoid Paying Penalties on Your IRA

Physician's Money DigestMay 2005
Volume 12
Issue 8

Should a physician heading towardretirement take money out of an IRAearly? This question is a good onebecause most people aren't sure what therules are—and they are slightly different fora traditional IRA and a Roth IRA.

Traditional Accounts

Normally, if you make a withdrawalfrom your traditional IRA before age 59 1/2you are subject to a federal penalty of 10%,plus you must report the withdrawal asordinary income. This double-whammyshould be avoided in all but the mostextreme situations. You can avoid thepenalty under the following circumstances:


•First-time homebuyers. Up to $10,000may be withdrawn by first-time homebuyers.The money can be used for your principalresidence, your spouse's principal residence,or the principal residence of yourchildren or grandchildren. The $10,000 isyour lifetime limit. However, if you are married,your spouse also has a $10,000 limit.Participants must pass the first-timehomebuyer test.

•Education expenses. Funds withdrawnfor post-secondary education expenses(eg, tuition and fees, books, supplies,and required equipment) for you,your spouse, your children, or grandchildrenare not subject to the penalty.

•Medical insurance premiums. Toqualify, you must have received federalor state unemployment benefits for aminimum of 12 consecutive weeks.

•Substantially equal distributions.This is a nifty little exception in the lawthat says you can avoid the penalty forearly withdrawal by taking the IRA fundsout in substantially equal paymentsaccording to a schedule provided by theIRS and based on your life expectancy.

It's important to note that while theseexceptions allow you to avoid the federalpenalty on early withdrawals, you will stillhave to include the withdrawals as incomefor income tax purposes.

Roth Action

Withdrawals from a Roth IRA are subjectto some of the same rules as the traditionalIRA, but there are some differences. Toqualify for an exception to the 10% federalpenalty, you cannot make any withdrawalsfor a minimum of 5 years from the date offunding your account. A little known fact isthat the date of your first deposit into theaccount is the date you must be concernedwith. Future deposits do not start a new 5-year clock running. In addition, many peopledon't realize that this 5-year rule applieseven if you are over age 59 1/2. The followingare the exceptions:

•Disability. If you are disabled, you canmake withdrawals free of penalties.

•Death. At your death, your benefi-ciary can take the withdrawals penaltyfree and income tax free.

•First-time homebuyers, educationalexpenses, and medical insurance premiums.Known as the 72(t) exceptions, theseare the same as for the traditional IRA.

The real power of the traditional IRAand Roth IRA is in allowing your moneyto grow in a tax-deferred manner for aslong as possible. Also, don't forget thatqualified withdrawals from a Roth IRA arenot subject to income taxes. Do your bestto avoid taking early withdrawals, but ifyou must, be sure to follow the rules toavoid paying the federal penalty.

Stewart H. Welch III, CFP

®, AEP,

is the founder of the Welch

Group, LLC, which specializes in

providing fee-only wealth management

services to affluent retirees

and health care professionals

throughout the United States. He is the

coauthor of J.K. Lasser's New Rules for Estate

and Tax Planning (John Wiley & Sons, Inc;

2001). He welcomes questions or comments at

800-709-7100 or visit www.welch group.com.

This article was reprinted with permission from

the Birmingham Post Herald.

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