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"Raiding The Retirement"

by Greg Mermel, C.P.A.

Published in the "Money and Taxes" column in PerformInk on November 21, 2008

My, how times have changed.

Just a year ago, I was writing advice about contributing money to retirement accounts. Now, I'm getting telephone questions about what happens if you have to take money out.

Not all retirement plans permit early withdrawals. Many employer plans do not, or make the process so complicated that it might as well be prohibited. All the various flavors of Individual Retirement Accounts (Roth, rollover, SEP and plain old traditional) do allow them, and it is generally pretty easy. Too easy, perhaps, because it makes the temptation harder to resist.

The Tax Cost

With limited exceptions that I'll discuss later, there is a ten percent "penalty" tax for withdrawals from a retirement account before you reach age 59 1/2, become permanently disabled or die. Whether you have yet turned 59 1/2 is not within your control. The other two are within your control, in a sick sort of way: don't drive drunk, always use a condom, and keep the suicide prevention hotline number on speed dial.

Let me address two common points of confusion.

Except for withdrawals from Roth IRAs that have been open for at least five years, whatever money you take out is subject to income tax at the same marginal rate as any other income. This could be ten, fifteen, twenty-five or as much as thirty-five percent, depending on your other income. The ten percent penalty tax is in addition to this regular tax -- not instead of it. The penalty tax also applies to otherwise non-taxable amounts taken from a Roth IRA.

Second, people tend to assume that the amount of federal taxes withheld on the payout will "cover" the taxes. This is almost never true. Withholding on retirement plan payouts is at an arbitrary twenty per cent rate. The penalty tax will eat up half of that, leaving ten per cent to apply to income tax. The very lowest income tax bracket is, indeed, ten percent, but it only applies to very low taxable incomes: below roughly $8,000 if single, or $16,000 if married, filing jointly. If your income is above that -- and if you are a self-supporting adult it probably is -- then you will owe taxes beyond the amount withheld.

Why, and Why Not

Before you take an early withdrawal from a retirement account, consider why you are doing it.

Good reason: you really, really, really need the money. Unpleasant, but valid in all circumstances. As somebody or other said, "desperate times call for desperate measures."

Bad reason: the value is shrinking faster than a cheap t-shirt in boiling water. This all-too-common situation calls for changing the investments, not yanking the money out. You can stop the bleeding and stash it in a bank account just as well inside a retirement account as outside, and you won't have to pay the regular or penalty tax.

Potentially good reason to take money out now when you know you will need it next year: you might miss some penalties, depending on the other 2008 torments in your personal financial hell.

Two by Two

The exceptions to the premature distribution penalty tax seem to cluster in twos. To start, all but two apply only to IRAs.

Of the two exceptions that do apply to employer plans, neither is particularly useful for most people. If you "separate from service" (quit, fired, laid off) after age 55, you can take money from an employer plan without penalty. You can also avoid the penalty tax if you shape the withdrawal from either type of plan as an annuity, taking same amount each month or each year for the rest of your life. That's potentially useful for early retirees, but not for younger folks who need more than that actuarially-determined amount right now.

Two relate to medical expenses. Penalty tax does not apply to withdrawals from an IRA up to "... the amount allowable as a medical expense deduction for the year, regardless of whether taxpayer itemizes." You almost certainly cannot know the exact deduction by year-end, since calculating it requires knowing your adjusted gross income for the year. And that may be impossible even if you have obsessive-compulsive disorder which manifests in your bookkeeping habits. But if you have significant medical expenses, an approximation might be let you withdraw money with minimal penalties.

The penalty is also waived on IRA withdrawals up to the amount you have spent on health insurance, provided you collected unemployment compensation for at least twelve weeks or would have save for being ineligible for unemployment because you are self-employed. Count the weeks carefully, since actors tend to go on and off unemployment.

Another pair probably are not likely to be useful this year. There is no penalty on amounts withdrawn from an IRA equal to the higher education expenses you have actually paid this year. Note that this refers to actual expenses, and not to paying off credit card or student loan debt incurred to pay them in an earlier year.

The other not-too-useful one involves first-time home purchases, and who the hell is doing that now? If you just raised your hand and said "me," you should know that you can take $10,000 out of your IRA without a penalty provided it is used for the purchase within 120 days of the withdrawal.

It Can Get Worse

The last two apply when life just really sucks. There is no penalty if a court orders you to give it to your ex-spouse as part of a divorce. And the IRS is gracious enough not to impose the penalty if they seize your retirement account for back taxes.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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