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.