Avoiding Penalty Taxes on IRA Distributions with Periodic Payments

Question: I recently lost my job and need to withdraw funds from my somewhat sizeable individual retirement account for living expenses. Since I have not yet attained age 59 ½, is there a way to avoid the 10% penalty tax on my IRA distributions?

Answer:  The IRS imposes harsh treatment for individuals who withdraw funds from their individual retirement accounts prior to attaining age 59 ½. As with all IRA distributions, ordinary income taxes are imposed on the taxable portion of funds withdrawn from an IRA. In the case of IRA owners who have not attained age 59 ½, an additional 10% penalty tax is imposed on the taxable portion of the IRA funds which are withdrawn. Accordingly, an individual receiving a premature withdrawal from an IRA is subject to income tax at the individual’s ordinary income tax rate along with a 10% penalty tax on the taxable portion withdrawn.

Various exceptions apply to the premature distribution penalty tax. Penalty-free distributions can be made for certain medical expenses incurred during a calendar year. Unemployed individuals can avoid the 10% penalty tax for IRA distributions used to pay health insurance premiums if various requirements are satisfied. If either of the foregoing or certain other relatively limited exceptions apply to you, then your IRA distribution will only be subject to income tax and not the 10% penalty tax.

Regardless of your circumstances, another exception, the periodic payment exception, will permit you to avoid paying penalty tax on the amount distributed. If an individual commences distributions from his or her IRA prior to attaining age 59 ½ and withdraws funds based on the individual’s life or life expectancy, the 10% penalty tax will not apply. While purchasing a commercial annuity and receiving payments over the IRA owner’s remaining lifetime is an option, the more popular choice is for an IRA owner to commence payments based on the individual’s life expectancy computed using IRS-promulgated life expectancy tables. When relying on the periodic payment exception to the penalty tax, the series of payments, once commenced, cannot be modified before the later of five years or the date the individual attains age 59 ½.

Depending upon the size of your IRA, the periodic payment exception may provide sufficient cash flow to you which will be taxable to you at ordinary income tax rates without the imposition of the penalty tax. One potential drawback to relying on the periodic payment exception is the inability to modify the payment schedule for the time period noted above.  If you are less than five years shy of attaining age 59 ½, you will be unable to receive larger withdrawals from your IRA until you have received five years of periodic payments. If you are more than five years younger than age 59 ½, then you need only wait until you attain age 59 ½ before modifying the payment stream.

Congress has imposed penalty taxes in an attempt to discourage individuals from withdrawing retirement account funds until they reach retirement years. Nevertheless, for persons who have certain needs such as yourself, careful navigation of the rules may provide an opportunity to tap into these accounts without having to pay penalty taxes.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.