Early Distribution from Traditional IRA

[artbuc]

What is the name of your state? PA and DE

I'm asking this question for my nephew who is 38 yrs old. Earlier this year he rolled over a qualified employer pension plan into a traditional IRA managed by Vanguard. This IRA contains $33,000 all of which is pre-tax employer contributions.

My nephew may need to withdraw about $5,000 later this year to pay some personal bills. After talking with IRS & Vanguard, and reading Publication 590, it appears that this will be a very simple and legal transaction. My nephew will receive one 1099 to report the tax-free rollover of the $33,000. He will receive a second 1099 to report the early distribution of the $5,000. He will have to pay income tax on the $5,000 plus he will have to pay the 10% penalty ($500) because he withdrew the $5,000 before he was 59-1/2 and he isn't using the early distribution for one of the approved exceptions, ie buying a first-time house.

My nephew's mother is alarmed about taking this early distribution. She believes it will trigger huge penalties and void his IRA altogether. She thinks that he will owe regular income tax on the full $33,000 even though he is withdrawing only $5,000. She also believes the IRS will impose much higher penalties than the 10% stated in their publications. I think my sister (nephew's mother) is confusing my nephew's traditional IRA with her employer's pension plan which allows employees to borrow pre-tax dollars if they pay it back. I explained that employer plans differ from traditional IRA's in this regard and that borrowing from a traditional IRA is prohibited.

Am I missing something? This seems so simple to me. The pre-tax dollars in my nephew's traditional IRA belong to him and the IRS doesn't care when he takes, how much he takes or how many times he takes it out. However, he will have to pay regular income tax on the total amount withdrawn in any given year plus a penalty equal to 10% of the total amount withdrawn until he reaches 59 1/2. Of course, the 10% penalty can be avoided if the money is used for certain approved exceptions.

Thanks for your help!

[seniorjudge]

The best answer I can give you is to talk to a tax CPA or, as a last resort, the IRS.

I think you are right but I am no tax attorney.

You may, however, suggest to the young fellow that he borrow the $5K rather than get it out of his IRA. Then, whatever he does, tell him to cut up all his credit cards and spend less than he makes.

[LdiJ]

Originally Posted by artbuc

What is the name of your state? PA and DE

I'm asking this question for my nephew who is 38 yrs old. Earlier this year he rolled over a qualified employer pension plan into a traditional IRA managed by Vanguard. This IRA contains $33,000 all of which is pre-tax employer contributions.

My nephew may need to withdraw about $5,000 later this year to pay some personal bills. After talking with IRS & Vanguard, and reading Publication 590, it appears that this will be a very simple and legal transaction. My nephew will receive one 1099 to report the tax-free rollover of the $33,000. He will receive a second 1099 to report the early distribution of the $5,000. He will have to pay income tax on the $5,000 plus he will have to pay the 10% penalty ($500) because he withdrew the $5,000 before he was 59-1/2 and he isn't using the early distribution for one of the approved exceptions, ie buying a first-time house.

My nephew's mother is alarmed about taking this early distribution. She believes it will trigger huge penalties and void his IRA altogether. She thinks that he will owe regular income tax on the full $33,000 even though he is withdrawing only $5,000. She also believes the IRS will impose much higher penalties than the 10% stated in their publications. I think my sister (nephew's mother) is confusing my nephew's traditional IRA with her employer's pension plan which allows employees to borrow pre-tax dollars if they pay it back. I explained that employer plans differ from traditional IRA's in this regard and that borrowing from a traditional IRA is prohibited.

Am I missing something? This seems so simple to me. The pre-tax dollars in my nephew's traditional IRA belong to him and the IRS doesn't care when he takes, how much he takes or how many times he takes it out. However, he will have to pay regular income tax on the total amount withdrawn in any given year plus a penalty equal to 10% of the total amount withdrawn until he reaches 59 1/2. Of course, the 10% penalty can be avoided if the money is used for certain approved exceptions.

Thanks for your help!

You are completely correct in your assessment of the situation. He will owe regular income taxes on the 5k, plus a 10% penalty. That means that his tax bite could be anywhere from 25% to 40% depending on his marginal tax bracket and taking state income taxes into consideration. He should keep that in mind when deciding how much to withdraw....and he should absolutely have Vanguard withhold enough federal and state income tax from the amount he withdraws. (he may have to seriously "fuss" with them to get them to withhold state income taxes) If he needs 5k for bills then he may need to withdraw as much as 8k, with proper withholding, to cover the taxes.

The only other possible problem, which is VERY unlikely (but does occasionally happen) is if his employer messes up on reporting the rollover on the 1099 that they will issue. If they don't report it as a rollover he is going to have some messy hassles to deal with, with the IRS, but if that is the case he will have those hassles whether he takes the additional money out or not. (and they will be resolveable hassles, it will just be a major pain to resolve)

He does not need to consult a tax attorney...that would be spending unnecessary money. Its clear that you and he understand exactly how the rules work. However, if he wants to consult someone to verify, he can consult an enrolled agent or any tax professional....its pretty basic stuff.

[tranquility]

I agree with LdiJ, it happens all the time and that is the way it is usually handled. Make sure there is nothing "weird" going on and you will be fine. ("Weird" being that important fact you didn't put into the post that changes everything--I can't think of one offhand, but know they lurk all over the place.)

On another note, think about the financial consequences. How are the funds held in the IRA? How much of a cost will there be from liquidating some of the investment to make a distribution? How much opportunity cost is lost because of the removal of the funds from the deferral of taxes? Unless the debt is a credit card debt, there may be more financially smart ways to deal with the situation.

[Snipes5]

The answers you received are correct.

If his mother is so concerned, see if she will loan him the money at a reasonable rate of interest, say 4-5%.

Snipes