More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
- Health Insurance: Health and Medical Savings Accounts A Health Savings Account is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary. Although they are popular, they are not without their pitfalls and the regulations can be complicated. Learn more about how to avoid federal taxation on the accumulation and distributions of HSA.
With the current state of unemployment in America, it wouldn’t surprise me if many unemployed or underemployed workers have had to tap into their retirement accounts just to make ends meet. Doing so can trigger tax penalties for those taking early distributions, therefore, the IRS recently released a Top 10 list about early IRA Distributions, in an effort to better inform taxpayers on the possible tax impacts.
There are, however, a few exceptions to the rule which may eliminate fines altogether or at least reduce the penalties. The following three exceptions tend to get overlooked, but definitely fall in the category of ‘your clients need to know’ information:
Distributions from qualified accounts with some form of an after-tax basis: This scenario arises from making nondeductible contributions to an IRA or rolling over after-tax 401(k) contributions into an IRA after severed employment or retirement. Those nondeductible/after-tax contributions result in a client having a cost basis in their IRA which could drastically reduce the tax owed on any distributions. Keeping up with the exact cost basis for tax purposes through detailed documentation will help keep clients from paying taxes on money that was previously taxed.
The easiest way to do this is to request that their tax professional complete IRS Form 8606 and maintain it within the client’s tax return records. The critical information here is that any distributions before or after age 59-1/2, which are related to a client’s cost basis in their IRA, are not subject to taxation or the 10% early withdrawal penalty.
Distributions for medical insurance expense: If a client is under age 59-1/2 and takes early IRA distributions in order to meet medical insurance premiums for family coverage, no 10% penalty is applied on those distributions as long as the following conditions are met:
- Client lost his/her job
- Client received unemployment compensation for 12 consecutive weeks because of losing his/her job
- Client received the IRA distribution either in the year of the unemployment compensation or the following year
- Client received the distribution no later than 60 days after re-employment. Therefore, if any of your clients have lost a job, make sure they don’t drop their health insurance coverage as they can use their IRA to pay those expenses without a 10% early withdrawal penalty
Distributions for higher education expenses: Just because your client lost his/her job doesn’t mean the funding of their children’s education has to stop. Clients can take withdrawals from their IRA before age 59-1/2 in order to fund higher education expenses without paying a 10% early withdrawal penalty.
The expenses have to be qualified higher education expenses (tuition, fees, books, supplies and equipment required to be enrolled at an eligible educational institution) to be exempt from the 10% penalty. The IRA 10% penalty distribution exception would apply to any family member, such as your client, their spouse, child or grandchild. One of the vital benefits this exception offers in this economic environment is that unemployed clients can use their IRA to fund their own education expenses if they desire to obtain a new college degree.
The withdrawals are still taxable at the federal and state level, but when combined with the possible education credits available within the tax code for qualified tuition and fees paid, the true tax burden owed may be substantially lower, in addition to the waived 10% early withdrawal penalty.
Here is a quick reminder of the most notable issues that qualify for the 10% withdrawal waiver exceptions on pre-age 59-1/2 distributions:
- Direct rollover of a retirement account to an IRA
- Fully and permanently disabled clients
- Inherited beneficiary IRA (Resulting from the death of the original qualified account owner)
- First time home buyer up to $10,000
- Qualified reservist distributions (those reservists called to active duty after September 11, 2001 for a period of time longer than 179 days)
- Unreimbursed medical expenses (exceeding 7.5% of adjusted gross income)
- Distribution due to an IRS levy of a qualified account to pay off of tax debt
- Substantial equal withdrawal payments (annuity calculation withdrawals involving the life expectancy of the owner. Distributions have to remain consistent for the greater of five years or to age 59-1/2)
- Distributions due to a divorce decree or separation agreement (qualified domestic relations court order)
Of course there are always specific documentation/reporting details required for any of the scenarios listed above in order for clients to qualify. Therefore, I highly recommend that you forward your clients a link to the IRS publication 590, an easy resource for reviewing all Individual Retirement Arrangements.
Taxes are most always inevitable in some form, but no one wants to pay more than they should, especially when employment for so many is hard to come by at this time. For those clients with after-tax contributions to their IRA or qualified plan, the need to continue their children’s education funding or looking to keep their medical insurance coverage, this may be just the information they need in this challenging economic climate.