What Are IRA Distribution Rules?

By Stephanie Powers

  • Overview

    Individual Retirement Arrangements (IRAs) are often the single largest amount of money people have. IRA owners may be tempted to dip into their nest eggs to fund life events other than retirement, such as sending kids to college. However, there may be tax consequences if IRA distribution rules are not followed. The rules change occasionally and vary according to the type of IRA.
  • History

    IRA distribution rules were created when the accounts were introduced in the 1974 Employee Retirement Income Security Act (ERISA). Key changes include allowing owners to spend retirement funds for college tuition and to purchase their first home. Occasionally ,special circumstances impact changes in the rules for IRA distributions. For example, Hurricanes Katrina, Rita, and Wilma led to the reversal of the 10% tax penalty on those economically impacted.
  • Function

    Since the growth of investments inside IRAs is not taxed, distribution rules control when or if taxes are paid on retirement funds. They discourage early withdrawal by imposing a tax penalty.

  • Types

    Traditional IRA distributions are taxable. Owners are penalized an additional 10% if withdrawals are taken before age 59 ½ (unless a qualified exception applies), and forced to withdraw a minimum amount annually after age 70 ½. Qualified Roth IRA distributions are not taxable. Qualified distributions occur 5 years after contribution, after age 59 ½ or if an exception applies. Non-qualified distributions are assessed a 10% tax penalty. SEP IRAs follow the same rules as traditional IRAs. Simple IRA distributions are taxable. If taken within 2 years of contribution, an additional penalty of 10% to 25% applies. IRA early distribution rules apply to the separate accounts of qualified employer retirement plans that are treated as IRAs. This includes 401(k), 403(a), 403(b), and 457 plans where employees defer salary amounts into IRA accounts.
  • Tax Penalty Exceptions

    There are exceptions to the early withdrawal penalty: IRAs inherited from another and not treated as your own Withdrawals used to pay college tuition and expenses First time homebuyers can use funds from their IRA to assist in the purchase Distributions taken in equal payments over the life of the owner The IRA owner is disabled To cover unreimbursed medical expenses greater than 7.5% of adjusted gross income To pay medical insurance premiums while unemployed You were economically harmed by hurricanes Katrina, Rita, or Wilma and took a distribution before 2007 Non-deductible IRA contributions withdrawn before taxes are filed You were a reservist called to duty between 2001 and 2007 Example: John is 50 years old. He takes $5,000 out of his IRA to buy a jet ski. Because John is under the minimum distribution age and his reason for the withdrawal is not one of the exceptions to the rule, his withdrawal is taxable and an additional 10 % penalty is due to the IRS. Withdrawal $5,000 Minus taxes $5,000 x .20 =$1,000 Minus penalty $5,000 x .10 =$500 Total taxes $1,500 Net amount of withdrawal $3,500 You can determine whether or not taxes on distributions are withheld at the time the withdrawals are taken. In the example above, John could request a check for the entire $5,000 and still owe the IRS $1,500 when he files taxes for the year in which the withdrawal occurred.
  • Identification

    IRS form 1099-R lists all IRA distribution amounts and types. The financial institution holding the IRA provides the completed form to the IRA owner regardless of whether distributions were taxable.
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