How To Avoid Paying Extra Taxes and Penalties in a Self-Directed IRA Part 2 – Early Distributions
When the government drafted ERISA, it was with the intent to incentivize Americans to save for retirement. It worked by giving them a tax break to keep their money in a special account and not touch it until retirement age. Well, what happens if you don’t play by the rules? Specifically, what happens when you feel a need for cash and take funds out of your Self-Directed IRA before you are ready to retire? This is known as an early distribution and the IRS responds by imposing financial penalties. Of course (as with any government regulation), there are exceptions to the law. Let’s break down the regulations and find out what you need to do to maintain your Self-Directed IRA tax advantage.
What is an early distribution?
When you contribute money to a Self-Directed IRA, the government expects the money to stay there until your reach a minimum age. That age is 59.5. After that you are free to withdraw the funds at will because you are considered within the retirement window. Any funds taken out of your Self-Directed IRA before the minimum age of 59.5 is considered an early distribution.
What are the consequences of an early distribution?
The consequences of an early distribution are tax liability and an additional penalty. The amount that you take out of your Self-Directed IRA will be added to your gross income for the year. That means you will be taxed at your current tax rate for the distribution. This tax rate is generally in not in your favor. If you are working and have any kind of income, your current tax rate will likely be higher than the rate you would pay after you retire. The exact amount you are charges will depend on the size of the early distribution and the level of the respective tax rates. Let’s look at a practical example.
Susan makes $70,000 per year working as an accountant. She hopes to retire in a few years, and at that point she expects to be bringing in $30,000 per year in taxable income. Due to a pressing family emergency, she takes a lump sum of $25,000 out of her Self-Directed IRA. How much more will she pay in taxes because of the early distribution? To answer this question we have to calculate 3 different numbers:
- The amount of tax owed on the early distribution
- The increased amount of tax owed on Susan’s regular salary
- The penalty imposed for an early distribution
Let’s run the numbers. At an income of $70,000, Susan currently (2021) is in a 22% tax bracket. However, the early distribution counts towards her gross income and pushes her into a 24% tax bracket. That means on the distribution alone she will pay $6,000. If she had not made the early distribution from her Self-Directed IRA and instead spread it out over her retirement years, then her expected $30,000 income would put her in a 12% tax bracket. The tax due on the $25,000 distribution would then only be $3,000. It comes out that the early distribution cost her a tax penalty of $3,000.
Now let’s look at the tax jump for Susan’s regular salary. The early distribution moved her from a 22% bracket to a 24% bracket. That may not seem like a large jump, but when applied to $70,000 it comes out to an increase of $1,400.
Finally let’s calculate the early distribution penalty. The IRS charges a flat 10% of the amount of the distribution. In this case where the early distribution was $25,000, the 10% penalty comes out to $2,500. Adding up all the different tax hikes and penalties together, it turns out that Susan will be paying an additional $6,900 because of the early distribution.
Exceptions to the early distribution rules
The IRS has made some exceptions to the early distribution rules where the account holder would be exempt from the 10% penalty. However, keep in mind that even in these cases standard tax liability would still exist.
- Medical expenses – Account holders who have medical expenses that will not be reimbursed by insurance have the option of turning to their retirement accounts. The early distribution can be taken without penalty to pay a large percentage of the medical bill. Specifically, the retirement funds can pay the total amount of the bill minus 7.5% of the account holder’s AGI (Adjusted Gross Income). For example, if a Self-Directed IRA account holder faced a medical bill of $23,000 and their AGI was $80,000, then they could use retirement funds up to the amount of $17,000. (That would be $23,000 – $6,000 = $17,000.)
- Higher Education – Early distributions used to pay for higher education may also be exempt from the 10% penalty. In order to qualify, the higher education expense must meet the following criteria:
- The education was paid for with taxable funds like a gift, income, or personal savings. Tax-free funds like Pell grants and veterans’ educational assistance would not qualify.
- The education must be for the account holder, their spouse, or their children and grandchildren.
- The educational institution has to be eligible. (Most accredited postsecondary institutions are eligible.)
- Qualified education expenses include tuition, fees, books, and supplies. Full time students (and certain half time students) may also count room and board.
- Disabled – If an account holder becomes disabled, then they would not be subject to penalties on early distributions. For this tax regulation, “disabled” is defined as a physician-certified condition that will lead to death or to indefinite inability to do gainful activity.
- Beneficiary – If an account holder dies before 59.5 years of age, the beneficiaries can immediately distribute the Self-Directed IRA without having to pay any penalties. One exception to this rule is a spouse who takes over the inherited Self-Directed IRA as their own. In such a case, they would have to pay the 10% penalty for an early distribution if no other exemptions applied.
- Other exemptions – Other exemptions to the 10% penalty include first-time home buyers, military reservists, a qualified birth or adoption, medical insurance payments, and distributions received in the form of an annuity.
Questions about distributions in a Self-Directed IRA? Contact a Madison Specialist.