Tap Retirement Funds Penalty-Free Age Can Play A Role IRA

Copyright 2009 Investor's Business Daily, Inc.All Rights Reserved
Investor's Business Daily

June 1, 2009 Monday NATIONAL EDITION

SECTION: Funds & Personal Finance; Pg. A08

LENGTH: 757 words

HEADLINE: Tap Retirement Funds Penalty-Free Age Can Play A Role IRA, 401(k) exemption rules differ for early withdrawal penalties

BYLINE: DONALD JAY KORN

Want to tap into your retirement money? Where you hold the funds can determine whether you get hit with an early withdrawal penalty.

Some people are better off siphoning cash from a 401(k). Others should look to an IRA.

You usually owe income tax when you take money out of an IRA or 401(k). And you probably will owe a 10% penalty if you withdraw before age 59 1/2.

Suppose a hypothetical John Taylor is 50 years old. When his company downsized last month, he was laid off. He set up a consulting business, but his pay is lower. Now he needs to tap his retirement fund to cover expenses.

One option for Taylor is to leave the money in his former employer's 401(k), then make withdrawals. But, given his age, he'll be hit with that early withdrawal penalty.

Say Taylor is in a 25% tax bracket. If he owes that tax plus the 10% penalty, he'll owe 35% on his retirement fund withdrawals.

That's the rate paid by the highest-bracket taxpayers. So Taylor would like to avoid the 10% surtax.

"If the money is still in a 401(k), there is no penalty as long as the account owner left the company after his or her 55 th birthday," said Natalie Choate, an attorney with Nutter McClennen & Fish in Boston.

In fact, he'd be exempt from the 10% penalty if his separation from service -- retirement, lay off, firing, quitting and so on -- occurred any time during or after the calendar year in which he reached age 55.

But Taylor is only 50 in this example. So he'd owe the 10% surtax on withdrawals.

There are some reasons to keep money in a 401(k), even if you leave the company before age 55. Payments to a spouse or a former spouse under a qualified domestic relations order in a divorce or separation avoid the 10% penalty, coming from a 401(k).

The IRA Rollover Route

Another option for Taylor is to roll his 401(k) account at his former work place to an IRA. Some exceptions to the early-withdrawal penalty apply to IRAs but not to 401(k)s.

One IRA exception is for first-time homebuyers. That is someone who has not owned a home that he used as his principal residence for the previous two years.

Taylor could take out up to $10,000 for a home he would occupy as his principal residence.

He also can withdraw the money and give it to his wife, child, grandchild or parent who's making a qualified home purchase -- or any combination of those people.

The $10,000 is a lifetime cap. If Taylor takes $4,000 from his IRA to help his son buy a home, he also can take $6,000 to help his daughter buy one. If both purchases qualify, there will be no penalty.

Taylor's wife can take out up to another $10,000, penalty-free, and give it to one or more qualified recipients.

To avoid the 10% surtax, the money must be used to buy or build a home within 120 days of withdrawal.

But Taylor doesn't plan to buy a home or help anyone else buy one. So this exception won't help.

Taylor can use another exception available to IRAs. That applies to outlays for higher education.

Suppose Taylor has two children in college this year. He expects to pay $30,000 for schooling in '09.

Taylor can withdraw up to $30,000 from his IRA this year and avoid an early-withdrawal penalty.

The money has to be spent at an accredited school. Expenses that count toward the penalty exception are those for tuition, fees, books, equipment and supplies.

For students who are enrolled at least half-time, penalty-free withdrawals also are permitted for room and board.

The student can be the IRA owner himself, the IRA owner's spouse, child, or grandchild -- or any combination of them.

An IRA rollover also makes sense if you lose a job and plan to go back to school to enhance your career prospects.

If you have lost a job, you might benefit from another exception to the 10% surtax. This exception applies to health insurance premiums.

You can withdraw IRA money to pay those premiums while you're unemployed, penalty-free.

To qualify, you must have received unemployment compensation for at least 12 consecutive weeks. The penalty-free withdrawals can be made in the year that unemployment compensation was received, or in the following year.

Health Help

That may be another reason to roll 401(k) money to an IRA if you leave the company before age 55. If you expect a long period of unemployment and substantial outlays for health insurance, you can take penalty-free withdrawals from an IRA but not from a 401(k).

So the reason you may withdraw funds can dictate where you should hold your retirement funds.

Usually, plans do not let members roll 401(k) assets to an IRA while they still work for the company.