Annuitizing Can Allow You to Tap Your Nest Egg Tax-Free

Written by Hersh Stern Updated Saturday, August 18, 2018

nest egg

Your IRA can be helpful in an emergency, and you can avoid the 10% bite for taking money out early. But you'll still owe income taxes on any withdrawal.

Sometimes, you just need the money now! You might have a sick child, lost your job or finally found the house of your dreams. Unfortunately, you listened to all those experts who demanded you put your investment dollars into an IRA first, and that's where all your cash is trapped.

If it's a traditional IRA, you got the deduction when you put the money in and expect to pay a tax when you take the money out. That's only fair.

But there's that 10% penalty that slams you if you take IRA distributions prior to age 59½. Technically, the IRS calls that a premature distribution. You'd report the penalty on Form 5329 when you file your annual 1040. But there are ways to jump the pond and grab your cash, without the additional 10% hit, even if you're not yet 59½. Here's how.

Annuitize

You can avoid the 10% penalty by withdrawing substantially equal annual amounts over your life expectancy until age 59½ or for five years, whichever comes later. So, if you're age 58, you must take withdrawals through age 63. But, if you're age 45, you have to continue to make withdrawals through age 59 ½. Once you finish making the required withdrawals, they can be modified or even stopped.

Your medical expenses are normally deducted as itemized deductions to the extent they exceed 7.5% of your adjusted gross income (AGI). IRA withdrawals are penalty free if used to pay for non-reimbursed medical expenses that exceed that figure.

So, if you have an AGI of $100,000, you can withdraw, penalty-free, up to your medical expenses in excess of $7,500. If your total medical expenses were $10,000, you'd qualify for as much as $2,500 in penalty-free withdrawals.

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Your withdrawal is sheltered from penalty, up to this amount, even if you don't itemize.

Here's where health insurance comes into play. The 10% withdrawal penalty doesn't apply to IRA withdrawals for medical insurance (without regard to the 7.5% AGI reduction) if the following two conditions apply to your situation:

1. You've received unemployment compensation under federal or state law for at least 12 weeks.

2. The withdrawal is made either in the year you received the unemployment compensation or the subsequent year.

Borrow it using the 60-day rule

The rule on borrowing from an IRA is simple on the surface: You can't borrow money directly from your IRA. You can't even use your IRA as collateral for a loan. But, you can back-door borrow. You do it with the 60-day free rollover allowance.

Let's say you've got $100,000 in your IRA. Even if you take out the money, you still have 60 days to roll over the distribution into a new IRA, both tax- and penalty-free. If you only have a short-term need for the money and can "repay" the full amount within the 60-day period, the rollover gambit will allow you tax and penalty-free access to your IRA dollars. Need more time?

The downside is that the IRS now wants 20% withholding on any distribution that's not a direct rollover into another plan. So, you're only going to get $80,000 in cash and will have to come up with the other $20,000 before the end of the 60-day period. Admittedly, that is expensive money.

The IRS also requires that you wait one year before making another rollover from that account. But, the limitation applies to each separate IRA you own. So, this one-year limit won't apply to a different IRA you may own.

"First-time" homeowners can use their IRAs

Surprise! To qualify for this 10% penalty shelter, you really don't have to be a first-time homeowner. This may really be your fifth home. But, you will qualify if you and your spouse have had no ownership interest in a primary residence for the two-year period ending on the date of acquisition of the new home. That's when the binding contract to purchase the new residence is signed or when construction begins.

Both spouses must qualify. If so, each spouse can withdraw as much as $10,000 without penalty. You can withdraw in chunks less than $10,000. But, this is a maximum $10,000 lifetime exclusion. And, the amount withdrawn must be used within 120 days of the date of withdrawal.

The residence may be for you, your spouse, child or grandchild.

College expenses

Withdrawals for higher-education expenses, such as tuition, room and board, fees, books, supplies and equipment can also be made penalty-free. You can even use the money for graduate-level courses.

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College expenses qualify if they're for you, your spouse, your kids or even grandchildren.

Death or disability, divorce and job loss

If you're disabled or dead, any IRA distributions made to you or to your estate come penalty-free. This is not something you plan on (unless tax and financial planning are very important to you). But, in the appropriate situation, it's nice to know you're not going to get killed by the penalty, too.

Other penalty exclusions include distributions made to an employee, age 55 or older, after separation from service. That's fancy tax talk for losing your job. You also escape the penalty if the distribution is made to your spouse under a qualified domestic relations order (QDRO), or if the distribution is made on account of an IRS levy.

Death, disability, losing your job, divorce and the IRS. I guess Congress thought those were the worst things that could happen to you and decided to give you a break on the penalty.

Inherited IRAs

Only a surviving spouse who is a beneficiary of decedent's IRA can roll those funds into his or her own IRA. If so, then distributions from the beneficiary's rollover IRA will both escape current taxation and qualify for the above penalty exceptions.

Since non-spouse beneficiaries don't have that option, they're going to be taxed on distributions. But the death exception will shield them from the 10% penalty.

Don't forget the income taxes

Let's say you've claimed you don't owe the 10% penalty, and the IRS rules otherwise. Can they go after the money? Indeed, they can and probably will. And you'll pay interest on the 10% as well.

One last point: We've only discussed alternative ways to avoid the 10% penalty on top of the normal tax. Regardless of what the money is used for, the dollars withdrawn from a traditional IRA are going to be taxed. And, regardless of their source, the distribution is going to be taxed as ordinary income.

So try to qualify for one or more of the exceptions. Otherwise, it's your money, but you'll cry if you take it.

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Comments (1)

  1. Richard:
    Nov 16, 2014 at 03:33 PM

    When one spouse dies what form is required to roll funds into his/her IRA? Both spouses are over 71 years old.