pension plan

When Distributions from Retirement Accounts Are Required

Share This:

Deductible contributions to IRAs and qualified plans are beneficial because they allow taxpayers to reduce their taxable income by the amount of the contributions.  The earnings within the retirement accounts are not subject to tax as long as the earnings remain in the retirement account.  However, the IRS doesn’t allow the party to last forever.  Eventually, taxpayers are subject to the minimum distribution rules that require taxpayers to withdraw funds from retirement plans and pay tax on the distributed amounts.  The rules discussed in this post apply to traditional IRAs and qualified plans.  These rules apply to Roth IRAs only after the owner’s death (i.e., the rules require beneficiaries of inherited Roth IRAs to receive minimum distributions; the original owners of Roth IRAs have no such requirement).

What Do the Minimum Required Distributions Rules Require?

Basically, these rules require the retirement account owner to distribute the balances in retirement accounts over her remaining life expectancy.  These rules require a minimum amount that must be distributed and taxed; the account owner is free to withdraw additional amounts from the retirement accounts.  Each year’s distribution is calculated independently.  No credit may be taken in the current year for prior year distributions that exceeded the required amount.

If an account owner withdraws less than the minimum required distribution, he is subject to a 50% penalty for the shortfall.

Example:  Terry’s minimum required distribution is $10,000.  She only withdraws $6,000.  She is subject to a 50% penalty on the $4,000 shortfall, which amounts to a $2,000 penalty.  Not good.

When Do Minimum Required Distributions Take Effect?

Minimum required distributions for IRAs are required starting April 1 of the year after the taxpayer reaches age 70½.  Generally, for participants of qualified plans, the minimum distribution rules take effect April 1 of the year following the year that the participant retires.  However, when the qualified plan participant owns more than 5% of the employer, the minimum required distributions are required in the year after the participant reaches age 70½ even if the participant isn’t retired.

An account owner reaches age 70½ six months after her 70th birthday.

Example:  John owns an IRA and turns 70 on January 16, 2012.  John therefore turns 70½ on July 16, 2012.  Minimum required distributions are required to be taken by April 1, 2013 (the year after he reaches age 70½).

The distribution required to be taken by April 1, 2013 is for 2012.  The distribution required for 2013 must be taken by December 31, 2013.  Therefore, if John waits until April 1, 2013 to take his first distribution, he will have to take two distributions during 2013 (one for 2012 and one for 2013).  The two distributions can bump John into a higher tax bracket, affect deductions and credits that are sensitive to income, and cause more of his Social Security income to be subject to tax.  John may be better off taking his 2012 distribution during 2012 rather than waiting until April 1, 2013.

How Is the Amount of the Minimum Required Distribution Calculated?

The simple answer is that the IRA trustee is required to report the minimum required distribution to IRA owners, or calculate it for them, by January 31 of the year the distribution is required.  However, it is the account owner’s responsibility to ensure that the calculated amount is correct.

The not so simple answer is that the minimum required distribution is calculated based on the account owner’s age at the end of the distribution year and based on the account balance at the end of the prior year.  Distributions are based on prior year balances because they are more readily determined than current year balances.

Example:  Jean turns 81 in 2012.  Her life expectancy is based on her age during 2012 (age 81).  Her life expectancy is 17.9 years.  She has two IRAs.  At December 31, 2011, IRA-1 has a balance of $100,000 and IRA-2 has a balance of $80,000.  Her minimum required distribution for 2012 for IRA-1 is $5,587 ($100,000 divided by 17.9) and her minimum required distribution for IRA-2 is $4,469 ($80,000 divided by 17.9).  The total required distributions of $10,056 can be withdrawn from one or both accounts.  

Only amounts that an individual owns as the IRA owner may be aggregated.  Amounts in IRAs that an individual holds as a beneficiary of the same decedent may be aggregated, but such amounts may not be aggregated with amounts held in IRAs that the individual holds as the IRA owner or as the beneficiary of another decedent.

For qualified plans, minimum required distributions must be calculated and distributed for each account–aggregation is not allowed for qualified plan accounts.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

How to Avoid the 10% Penalty on Early Retirement Account Distributions

Share This:

One issue with investing money in a 401k or IRA is that you generally cannot access the funds until you reach age 59½.  If you withdraw funds from these retirement accounts before that age, you will be subject to a 10% penalty on the amount distributed.  This penalty is in addition to the federal and state income taxes you’ll pay on the distribution.

Fortunately, the IRS will waive the 10% penalty in certain circumstances.  However, even if you meet one of these exceptions, you’ll still have to pay federal and state income taxes on the distribution even if the 10% penalty is waived.

The exceptions are:

  • Distributed funds that are rolled over into an IRA or other qualified plan
  • Distributions upon death or disability of the account owner
  • Distributions that are part of a series of substantially equal periods payments over the life of the account owner or the joint lives of the participant and beneficiary
    • Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity).  These annuity payments are exempt from the 10% penalty.  The annuity has to last through the later of:
      • When the account owner turns 59½
      • Five years after the date annuity payments began
  • Distributions after the participant’s separation from service (i.e., quitting/laid off/fired), provided the separation from service occurred during or after the year the participant reached age 55 (or age 50 for government plans to a retired police officer, firefighter, or emergency medical services provider).
    • This exception applies only to qualified plans, it does NOT apply to IRAs
  • Distributions to a former spouse under a Qualified Domestic Relations Order (QDRO)
    • Pension benefits are often divided during divorce.  To properly comply with pension plan rules, retirement accounts can only be split up pursuant to a QDRO.  Otherwise, the plan will have made a disallowed distribution to a nonparticipant.  This could jeopardize the tax-advantaged status of the pension plan.
    • Once a retirement account has been divided pursuant to a QDRO, the nonparticipant spouse can receive distributions without incurring the 10% penalty.  However, the nonparticipant spouse is still subject to the pension plan rules and isn’t entitled to any type or form of benefits that aren’t available in the plan.
    • IRAs do not require QDROs to be divided in divorce.  The division of the IRA does not cause a distribution; however, amounts withdrawn from the IRAs by either spouse will not be exempt from the 10% penalty if it is a disqualifying distribution.
  • Distributions to the extent of deductible medical expenses
    • Medical expenses are reduced by 7.5% of adjusted gross income to arrive at deductible medical expenses.  Early distributions equal to this amount can be distributed free of penalty.
  • Distributions made on account of the IRS’ levy of retirement accounts

The following exceptions apply only for IRAs:

  • Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks.  The reduction for 7.5% of adjusted gross income does not apply.
  • Distributions used to pay for qualified higher education expenses (college) for the account owner, owner’s spouse or child/grandchild.
  • Distributions up to $10,000 for first time homebuyers.
    • “First time” doesn’t literally mean “first time.”
    • First time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.
.

Get Our Posts by Email


Created by Webfish.