Telling Tips is a series of articles from local experts to help you save money, make better decisions and plan for a better future.
As the economy continues its course to the basement, I’m receiving more and more calls about money to pay for medical insurance and expenses, college costs, living expenses due to job loss, and more. The best thing about these calls are the calls themselves, because they show that you know that taxes are involved, and that your barber has not given you the information you feel is complete or correct.
The first question I get is “Can I take a withdrawal from my retirement without tax?” The answer is: No. Beginning with your first job, you have been advised to save for retirement. Now when you need the money for current emergencies, it’s trapped. You contributed to your various retirement accounts — IRAs, 401(k)s, etc. — and received a tax reduction with the expectation of having to be taxed when withdrawn. If you withdraw your funds before age 59-and-a-half, you are subject to not only the tax, but a 10 percent withdrawal penalty — even before you get your money.
This distribution can cost you up to 40 percent of the withdrawal between the penalty, and federal, state, and local taxes. So, before this, I advise you to:
- Prepare a budget and see exactly where your money is going, and
- Look into credit card advances, borrowing from family and friends, and selling unneeded assets.
Even though the taxes will have to be paid on the principal, you may be able to get around the 10 percent penalty. There are actually 10 (ten) exceptions. These apply to your IRA accounts:
Borrowing For 60 Days Or Less: Borrowing directly from your account is not allowed. You can’t even use IRA money as collateral for a short-term loan. What you can do, however, is take out the funds and “repay” the full amount within this 60 day window. The negatives:
- The IRS requires a 20 percent withholding on the distribution to you. So, if you need $100,000, you’re only going to get $80,000, with $20,000 going to the IRS. When you repay in 60 days, you have to repay the full $100,000, and wait until income tax time for the $20,000 that was withheld. If you only repay the $80,000, you’ll get hit with tax and penalty ON the $20,000.
- You can only do this once per year from that account.
Loophole: The once-per-year limitation only applies to that one account. You can “borrow and repay” from each IRA account you have.
Medical Expenses: If you itemize your deductions, you know that medical expenses can be deductible if they exceed 7.5 percent of your Adjusted Gross Income (AGI). As an example, if your AGI is $100,000, and your total medical expenses are $10,000, you can deduct the amount over $7,500 (7.5 percent), or $2,500. If you use your IRA withdrawal to pay for these medical expenses, the excess amount — in this case the $2,500 — would not be subject to the penalty, but the $7,500 would be.
IRS Gotcha: The full $10,000 is added to your AGI and therefore your 7.5 percent threshold is increased by $750.
Loophole: The penalty exception applies whether or not you itemize.
Medical Insurance Exception If Unemployed: If you withdraw funds to pay for medical insurance for yourself, your spouse, and your dependents, you can avoid the penalty if:
- You lost your job, and
- You received unemployment benefits for 12 consecutive weeks (because of job loss), and
- You make the withdrawal in the year, or year following, the 12-week unemployment test is met, and
- The distribution is made no more than 60 days after returning to the work force.
Self-employed? If you are ineligible by law for unemployment benefits because you are self-employed, the IRS considers you as having met the 12-week test.
Higher Education Expenses: Although tax is due, the penalty is avoided if you paid for higher education expenses, including grad school, for you, your spouse, you or your spouse’s children or grandchildren, who is at least a half-time student.
These expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance, and room and board.
Note that the expenses must be paid during the year of the IRA distribution. In other words, you can’t take a distribution in 2012 to pay for tuition in 2013, nor can you take a distribution in 2012 to pay for 2011 tuition. The IRA withdrawal must be made in the same year that the qualified higher education expenses were incurred.
First-Time Home-Buyer Expense: Need an extra $10,000 for “first-time” home buyer expense? The penalty is avoided, but taxes on the amount withdrawn are still due. The key here is the meaning of “first-time.” According to the lawmakers, “first-time” applies if you did not own any principal residence in the two-years ending on the acquisition date of the new home. This applies to your spouse also.
Loophole: If you qualify, you can help take this distribution for your children, grandchildren, or parents.
Loophole: The $10,000 is for your IRA. Your spouse is also able to withdraw $10,000 from their IRA.
Note: The taxable portion of your IRA withdrawal only applies if you took a full deduction for your IRA contributions. If you made non-deductible contributions, a percentage of your withdrawal will not be subject to tax at all. Make sure you retain a copy of all of your prior year tax returns, and file Form 8606 every year, including years when you are not required to file. If you haven’t, gather your tax returns for 1987 and forward, and complete Form 8606.
Other Exceptions For IRA Owners: The other exceptions for IRA owners, although beyond the scope of this article, are rollovers, permanent or total disability, IRS levy, annuity withdrawal, spousal beneficiary withdrawals, and qualified reservist withdrawals.
Non-IRA Withdrawal Exceptions: The above are for IRA accounts. There are few exceptions, which apply to a 401(k) or 403(b) plan. These are withdrawals for disability, age, annuities, unreimbursed medical, and divorce.
If you have questions, please call your tax preparer, or this office at (718) 332-1040 for clarification or help.
Quip: Did you know — broken pencils are pointless.
Have a good week.
Joseph Reisman, of Joseph S. Reisman & Associates, has been serving tax prep and business accounting expertise from his Coney Island Avenue office for more than 25 years. Check out the firm’s website.