Structuring IRA Distributions To Prevent Penalties - Safe Harbor Planning: Several Useful Methods

IRA distribution rules are a mine field. One incorrect move and you can discover yourself faced with high taxes and penalties which could wipe out years of savings and investment. Complicating issues is the Darwinian evolution of IRAs which have taken place since the pioneer IRA was introduced in '74 with the enactment of the Employee Retirement Income Security Act (ERISA ). Since 1974, IRA rules have altered dramatically and legislation was enacted to severely punish those who do not follow the regulations, to the letter of the law. IRAs come in lots of flavors but, for reasons of this article we will focus on the 2 key kinds of IRAs: Traditional IRAs and Roth IRAs.

Approaches for Minimizing Penalties on Early Distributions

Generally, any distribution from an IRA before you reach age 59 1/2 is considered an early distribution and is matter of a ten percent penalty on the taxable amount received in a distribution. There are specific IRA distribution rules that can be used to avoid the imposition of this early withdrawal penalty.

1. Using IRA Funds to Purchase or Build Your First Home - Up to $10,000 might be withdrawn from an IRA as an early distribution penalty-free, so long as the distribution is used to buy, build or rebuild a first home for yourself, your wife, you or your spouse's kid, you or your spouse's grandchild or you or your wife's parent or ancestor.

2. Using IRA Money for Medicinal Bills - Penalty-free early distributions can be made if the funds are used to pay unreimbursed medicinal bills which exceed 7.5 percent of your adjusted gross earnings. There is no condition to itemize deductions to be eligible for this exception.

3. Using IRA Money for College Costs - Traditional IRAs can be also tapped to aid fund school expenses; however, the taxable amount of the distributions from these IRAs will be matter of income tax in the year of the distribution.

Roth IRA distribution rules

Roth IRAs have unique rules with respect to distributions. Contributions withdrawn aren't subject to the ten percent penalty and there's no RMD with Roth IRAs. In order for Roth IRA earnings distributions to be tax-free, the account must have been opened for five years and the distributions must be made after reaching age 59 1/2. If you fullfil the 5-year rule but not the 59 1/2 year rule, distributions in excess of your contributions will be taxable and matter of a ten percent penalty.

1. No RMD - With Roth IRAs, there is no RMD at age 70 1/2. This means a Roth IRA operator is never needed to make a distribution out of their Roth IRA. Because of this, Roth IRAs can grow, untaxed, throughout the lifetime of the owner, permitting a larger legacy for their beneficiaries.

2. 0% Effective Tax Rate - Qualified distributions from Roth IRAs aren't subject to income tax...ever. This means you are unaffected by future tax increases as your effective tax rate is always the same...zero.

3. Conversion Possibilities - Beginning after January 1, 2010 anybody, irrespective of their income level, may convert traditional IRAs into Roth IRAs. The tax on the taxable income for 2010 conversions can be delayed into 2011 and 2012. If you do not have enough money set aside to do a 100% conversion you can do partial conversions.

4. College Expenses - Because Roth IRA contributions may be withdrawn, tax-free, penalty-free, at any time, such contributions can be a tax-free future funding source for your child's academy expenses.