AVOIDING THE 10% PENALTY IN 5 EASY STEPS
What is the 10% penalty?
A 10% early distribution penalty applies to taxable distributions made before age 59 ½. Distributions made after age 59 ½ are not subject to the 10% early distribution penalty.
Exceptions: Age 55 for employer plans when you separate from service in the year you turn 55 or later; age 50 for public safety employees in governmental defined benefit plans who separate from service; for SIMPLE IRAs, the penalty is 25% in the first two years in the plan then reverts back to the 10% penalty in following years.
- Check the age of the IRA owner, look for an exception to the penalty. The main exceptions are disability, death (distributions to beneficiaries are never subject to the penalty), medical expenses in excess of 7.5% of AGI (adjusted gross income) in 2012 and 10% for 2013 and after in the year of distribution, first-time homebuyers, higher education expenses, and health insurance for the unemployed receiving unemployment compensation for 12 consecutive weeks.
- If no other exceptions are available, pick one of the IRS approved methods under Code Sec. 72(t). The three methods are: annuitization, amortization and the Required Minimum Distribution method (RMD). The interest rate used for the amortization and annuitization methods cannot exceed 120% of the federal midterm rate in either of the 2 months preceeding the first distribution. There are Internet calculators to help with these calculations.
- 72(t) payment modifications. Once a 72(t) payment plan is established it cannot be modified during the payment period except in the case of death, disability or a one-time (penalty-free) change from the annuity or amortization method to the RMD method. If a modification does not fit into any of these categories, the 10% penalty is applied retroactively to all distributions taken before age 59 ½ plus interest.
- Take advantage of change. An IRA owner who initially needs larger 72(t) payments can use the fixed amortization or annuity method and then switch to the RMD method when larger distributions are no longer needed.
- Stay on top of annual distributions. Follow up with the plan provider to ensure that distributions are coded correctly. If using the 72(t) exemption, keep track of annual distributions and the number of years left.