Sep 06, 2019

Tax Management with Unconventional IRA Distributions

Ashley N. Blessing, CPABy Ashley N. Blessing, CPA

MoneyLife100An individual retirement account (IRA) is an excellent tool for saving for retirement. However, there may be an occasion that arises when the monies saved need to be accessed for costs other than retirement. If the reason for the withdrawal is not one of the exceptions outlined by the IRS, the amount withdrawn is subject to income tax in addition to a 10% early distribution penalty.

As a reminder, a traditional IRA is a tax-deferred contribution into a retirement account. That means an amount contributed into an account is deducted from that year’s earnings, and taxes are deferred on this amount (and the interest earned) until it is withdrawn from the retirement account. For Roth IRAs, the taxpayer pays income tax on the contribution when the contribution is made, but the earnings are tax-free when withdrawn.

Meeting with a Financial AdviserThere are slight differences in the taxability of early withdrawals between traditional and Roth IRAs. For a traditional IRA, the contributions that you were previously able to deduct and the earnings are subject to both tax and a 10% penalty. If your reason for the withdrawal meets one of the defined exclusions from penalty set by the IRS, then the penalty charge would be avoided. For a Roth IRA that you have had for less than five years, the earnings are taxable and subject to the 10% penalty. You may be able to avoid the penalty if your reason was among the allowable exclusions. If you had the Roth IRA for longer than five years, the earnings would not be taxable if the reason was permitted by the IRS.

For traditional IRAs, the contributions that you were previously able to deduct in addition to the earnings will be taxed as ordinary income. You may be able to avoid the 10% early withdrawal penalty if the reason aligns with these exclusions: first time home purchase (limited to $10,000 lifetime maximum), qualified education expenses, if unemployed and you use the proceeds to pay for unreimbursed health insurance, medical expenses that exceed 7.5% of your adjusted gross income (AGI), IRS levy, as well as exceptions provided to members of the National Guard. Each of these exceptions has their own set of rules which will need to be considered in more detail if you will be using them.

For Roth IRAs owned less than five years, the earnings on the contributions would be taxed as mentioned, but no 10% early withdrawal penalty would be assessed if any of the following was met: first time home purchase (limited to $10,000 lifetime maximum), qualified education expenses, you are a least age 59 ½, if unemployed and you use the proceeds to pay for unreimbursed health insurance or medical expenses, or you become disabled. If the Roth IRA is more than five years old, the earnings would not be subject to tax nor would there be a penalty for the same reasons above, minus the qualified education expenses.

As with everything tax related, before any withdrawal is made it is imperative that you speak to a tax professional about your specific situation to avoid any tax traps.

Ashley N. Blessing, CPA, is a supervisor with Herbein + Company Inc. in Reading, Pa. She is co-chair of the Reading Chapter Emerging CPAs Committee and a member of the Reading Chapter Community Engagement Committee.

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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.