How to Avoid Penalties on IRA Distributions

Distribution rules from IRAs are complex. Learn how you can avoid penalties on your IRA distributions in retirement.

When you made contributions to your IRA or 401k you made a deal with the IRS that, in return for the deduction, you would pay ordinary income taxes on the distributions you take in retirement. That turns out to be a good deal for the IRS. If you took a $2,000 deduction when you were twenty-five, and that money grows to $29,949 when you are sixty-five, assuming a 7% growth rate, you will now pay taxes on the $29,949 – an you only got a $2,000 deduction! Maybe it would have more sense to put it in a Roth IRA but, unfortunately, Roth IRA’s were not available then.

It is bad enough to have to pay taxes on these withdrawals; don’t put yourself in a situation to also pay penalties along the way. The most common penalties are:

  •  10% penalty for withdrawals before age 59 ½.
  •  50% penalty for withdrawals less than the Required Minimum Distribution at ages over 70 ½.
  • 50% penalty for withdrawals less than the Required Minimum Distribution from inherited IRA’s for all ages starting the year after death of the person inherited from.

We will look at how these penalties can be avoided.

10% Early Withdrawal Penalty

If you take a withdrawal from a traditional IRA at any time before you reach age 59 ½, you will be charged a 10% penalty in addition to the ordinary income taxes you pay. This penalty is due even if you have no other taxable income.

There are two ways to avoid this penalty, in addition to the obvious of waiting until you are 59 ½ to take the withdrawal. The first is to set up a Code Section 72t Distribution. This section allows for a withdrawal from a traditional IRA at any age provided you follow the following rules:

  • You must take Substantially Equal Period Payments using one of three calculation methods.
  • You must use a Reasonable Interest Rate to calculate the payments; this is any rate less than or equal to 120% of the Federal Mid-Term rate.
  • Payments must continue for five years or until you reach age 59 ½—whichever is greater.

The calculation methods are to complex to cover in the article but we would be happy to do the math for you. Based on the current mid-term rate a person at 55 could take annual payments of about 5.3% of the IRA account balance.

Another way that you could possibly take funds out early is through your company sponsored plan. You can begin taking penalty free withdrawals from employer sponsored plans, such as 401ks, as early as age 55 if you fully retire from your company at age 55 or greater, and do not go to work for another company. The only problem with this strategy is that most company sponsored plans have a mandatory 20% federal withholding requirement which is higher than most retiree’s effective federal rate. This can often be mitigated by doing a partial rollover to a traditional IRA and doing a 72t distribution, with no tax withholding, and take the remainder of the funds needed from the amount left in the employer plan.

50% Penalty on Withdrawals less than your RMD

The year you turn 70 ½ you need to start Required Minimum Distributions. In the first year you have until April 15th of the following year to take the distribution and in subsequent years you have until December 31st of the current year. Taxes are paid the year the distributions are taken so it typically makes sense to take the first year’s distribution before year-end so you don’t pay taxes on two distributions the following year.

If you have several IRAs it doesn’t matter which IRA the distribution it taken from. To calculate the RMD you add up the previous year end balances of all IRAs and divide the total by the factor found on the IRS’s Uniform Lifetime Table. You use the factor for your age on December 31st of the current year. For instance, if you turn 70 ½ on January of the current year you would use age 71 (the age you will be at year end) while someone turning 70 ½ in November of the current year would use age 70.

If you let a year slip by without taking the distribution—or several years—you should take the past RMD’s as soon as you realize the error. The IRS can waive the penalty if you provide a reasonable explanation and report the error on form 5329 which you file with your next 1040 return.

50% Penalty on Withdrawals less than your RMD on Inherited IRA’s

Many people make the incorrect assumption that they can wait until 70 ½ to start taking withdrawals from Inherited IRAs. You must start taking RMD’s the year after the death of the person you inherited the IRA from. The RMD is calculated using the IRA’s Single Life Table. Unlike the table used for your own IRA you don’t return to the table each year, you simply subtract 1 each year from the original RMD factor. If you have missed any Inherited IRA distributions you can file for a waiver of penalty as outlined above.

Distribution rules from IRAs are complex. I would be happy to send you a free copy of my book that explains these rules in detail. If, like most people, learning complex IRS rules isn’t your idea of a good time I’d be glad to review your individual situation and outline the steps you need to take to keep yourself on the right side of the IRS.

Bruce Larsen is Presidential Wealth Management’s Director of Enterprise Solutions as well as a senior financial advisor. Bruce is also the author of A Concise Guide to Taxes in Retirement and the creator and developer of Legacy Guide.

FREE BOOK OFFER

A Concise Guide to Taxes in Retirement is the number one book on Amazon for taxes in retirement. Bruce would be happy to mail you a free copy, at no cost or obligation. In the near future, Bruce will conduct a taxes in retirement webinar that you can attend from the comfort of your own home. He will also be teaching a live, in-person taxes in retirement workshop.

If you are interested in the book offer, the taxes in retirement webinar or workshop, or a personal meeting with Bruce, simply check the boxes that apply and he will follow up shortly. Thank you.

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