When It’s OK to Tap Your IRA

You’ve been saving diligently for your retirement, but now you need some of that cash to cover today’s expenses. Can you get to it without incurring Uncle Sam’s tax wrath? In some instances, the answer is yes.

When you take money out of an individual retirement account before you reach age 59½, the Internal Revenue Service considers these premature distributions. In addition to owing any tax that might be due on the money, you’ll face a 10 percent penalty charge on the amount.

But there are times when the IRS says it’s OK to use your retirement savings early.  Two popular, penalty-free withdrawal circumstances are when you use IRA money to pay higher-education expenses or to help purchase your first home.

OK for School

When it comes to school costs, the IRS says no penalty will be assessed as long as your IRA money goes toward qualified schooling costs for yourself, your spouse or your children or grandkids.

You must make sure the eligible student attends an IRS-approved institution. This is any college, university, vocational school or other postsecondary facility that meets federal student aid program requirements. The school can be public, private or nonprofit as long as it is accredited.

Once enrolled, you can use retirement money to pay tuition and fees and buy books, supplies and other required equipment. Expenses for special-needs students also count. And if the student is enrolled at least half time, room and board also meet IRS expense muster.

First-Home Exemption

Then, there’s your home. Uncle Sam offers various tax breaks for homeowners. He’ll even bend the IRA rules a bit to help you get into your house in the first place.

You can put up to $10,000 of IRA funds toward the purchase of your first home. If you’re married, and you and your spouse are first-time buyers, you each can pull from retirement accounts, giving you $20,000 in residential cash.

Even better is the IRS definition of “first-time homebuyer.” Technically, you don’t have to be purchasing your very first abode. You qualify under the tax rules as long as you (or your spouse) didn’t own a principal residence at any time during the previous two years. In fact, you can even share your IRA wealth. The IRS says the first-time homebuyer using your IRA funds for a down payment can be you, your spouse, one of your children, a grandchild or a parent.

But be careful not to take out your money too soon. You must use the IRA funds within 120 days of withdrawal to pay qualified acquisition costs. This includes the costs of buying, building or rebuilding a home, along with any usual settlement, financing or closing costs.

Different Treatment for Roth

These home buying IRA options apply to traditional retirement accounts. The rules are a bit different if your nest egg is in a Roth IRA.

The $10,000 you take out for your first home is a qualified distribution as long as you’ve had your Roth account for five years. This means you can take out your retirement money without penalty, and because Roth earnings are tax-free, you’ll have no IRS bill, either.

If, however, you opened your Roth IRA less than five years ago, the withdrawal is an early distribution. As with a traditional IRA early withdrawal, a Roth holder can use the first-home exception to avoid the 10 percent penalty but might owe tax on earnings that are withdrawn.

You can reduce the tax bite by first withdrawing the already-taxed contributions you made to your Roth. In fact, the IRS has specific rules about the order in which you can take unqualified Roth distributions: contributions, conversions from traditional IRAs and earnings. Check Chapter 2 of IRS Publication 590, Individual Retirement Arrangements for details.

Military Exceptions

Members of the military reserves also can receive early IRA distributions without penalty. To qualify, the following conditions must be met:

Conditions:

• You were ordered or called to active duty after Sept. 11, 2001.

• You were ordered or called to active duty for a period of more than 179 days or for an indefinite period because you are a member of a reserve unit.

• The distribution is from an IRA or from an elective-deferral plan, such as a 401(k) or 403(b) plan or a similar arrangement.

In addition, the early distribution cannot be taken before you received your orders or call to active duty or after your active duty period ends.

Personnel eligible for this early withdrawal exception include members of the Army or Air National Guard; the Army, Naval, Marine Corps, Air Force or Coast Guard Reserves; and the Reserve Corps of the Public Health Service.

Allowable, But Not Preferable, Distributions

Early IRA withdrawals also are penalty-free in a few other instances. Unfortunately, most of these are hardship situations that no taxpayer wants to face.

Hardship circumstances for penalty-free withdrawals:

• Payment of excessive unreimbursed medical expenses.

• Payment of medical insurance premiums while unemployed.

• Total and permanent disability.

• Distribution of account assets to a beneficiary after you die.

You also can get IRS-approved early access to your nest egg if you take IRA money on a specific schedule. Known as substantially equal periodic payments, this method allows you to begin withdrawing from your IRA early as long as the amounts are determined by an IRS-calculated life expectancy table.

Finally, keep in mind that the early withdrawal exceptions do not eliminate your tax bill if you take the money out of a traditional IRA. Unlike Roth accounts where you eventually can withdraw your money tax-free, taxes are merely deferred on traditional IRAs. So when you take the money out of such an account, regardless of your age or the purpose of the withdrawal, you’ll owe your regular tax rate on the amount.

But the early withdrawal exceptions do protect you from paying the IRS more in penalty charges. To let the IRS know that you used the retirement money early for a tax-acceptable purpose, file Form 5329. When you report your withdrawal here, you’ll also enter a code, found in the form’s instructions, that lets the IRS know the distribution is penalty-free.

The information herein contained does not constitute tax advice.  Any final decisions or actions should not be made without first consulting a CPA or Accountant.

For more information contact us at 845.563.0537 or Contact@CompassAMG.com

The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm.  Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.

Retirement Success – Decoding the Mystery

Millions of Americans fear the unknown – Retirement. They fear not having enough money to live comfortably. They fear becoming dependent on their children because they cannot afford to make it on a fixed income.

“Americans’ confidence in their ability to afford a comfortable retirement has plunged to a new low,” says the latest annual Retirement Confidence Survey from the Employee Benefits Research Institute, a respected nonprofit think tank.

Fewer than 50% of workers are confident about their ability to retire comfortably. The number “very confident” has halved in a few years to just below 13%. 

Meanwhile, the number who have no confidence at all has nearly tripled, and now stands at 27%. More than one in four.

A similar number of people question whether they will even be able to meet their basic expenses.

I am convinced one of the biggest problems is that people don’t know how much money they will need to retire comfortably. Many don’t even know where to begin. Unfortunately, many advisors are too focused on returns and not enough on planning to meet those needs. The most populular planning method for retirement seems to be guessing.

Don’t leave your happiness and success to guesswork!  If you’re totally baffled, try these six simple steps. It’s not a plan. But it’s something anyone can do in 10 minutes or less, and it will give you a much better idea where you stand—and what you need to do.

1. Figure out how much income you’ll need

What sort of income will you need each year in retirement? What will be comfortable? What will mean real hardship?

Some people will tell you to sit down and draw up an elaborate budget. And maybe that’s the perfect solution, but you could take a shortcut instead.  At a pinch, for most people the best guess for the income you’ll need to live on in retirement comfortably is about the same as the income you need now.

Obviously, a few things will be different in retirement. You’ll no longer have to set aside money to save for retirement, for starters. If you expect to pay off your mortgage by then, you’ll no longer have to set aside money for that. The same goes for putting kids through college. But once you’ve eliminated those costs, the best way to calculate the disposable income you’ll need in retirement is to look at the disposable income you have now.

Sure, you can make adjustments. You may find you’re comfortable with less, or you may want more.  But when you are dealing with the unknown, it helps to start with something familiar. In this case, try your current disposable income.

2. Figure out how much you will get from outside sources

That means how much you will get from Social Security. It may also mean how much you will get from any other pension plan, if you are among the diminishing few who has one.

Social Security is central to most Americans’ retirement plans. It is an inflation-protected annuity that will last your lifetime and where the insurer, Uncle Sam, won’t run out of cash. This is why it’s such a political hot potato.

What does Social Security mean for you? The Social Security Administration posts an online calculator that will help you work out what to expect in benefits. As of 2011, the average retired single worker gets $14,000 a year. The average couple: $23,000.

If you are among the shrinking group of people eligible for a pension, you should work out how much you are going to get from that as well. Add that to your expected Social Security benefits.

3. Figure out how much income you will need from your investments

Once you know how much income you’ll need (step 1) and how much you can expect from Social Security and any private pension plan (step two), it’s easy to work out how much you’re going to need from your own investments.

At the risk of stating the blindingly obvious, it’s what’s left over. For those who have been using computers for too long, subtract item two from item one.

That means a married couple that lives on $40,000 a year in disposable income, has no pension and expects Social Security benefits of $23,000 a year is going to need to provide $17,000 a year from its own resources.

4. Understand how long your investments will have to last

In other words, how long you’re likely to live in retirement.  There’s a very good chance it’s longer than you think. That’s great news, of course. But it doesn’t help your math.

The average life expectancy in the U.S. these days is about 75 for a man and 80 for a woman. Those data are from the U.S. Census. And they’re completely useless for retirement math.

Why? Because you are unlikely to be exactly average and your fears are asymmetric. From a purely financial standpoint, you don’t want to outlive your savings, even by a couple of years.

Furthermore, those life-expectancy figures are measured from birth, not from age 65. Much more useful are the cohort survivorship figures calculated by the U.S. Department of Health. Of those who make it to 65, 25% will go on to live to 90, they show. Among women it’s 30%. And of women who make it to 65, 12%, or one in eight, will live to 95. Quite a few, about 3%, will live to 100.

If you live into your 80’s or beyond, you do not want to find yourself there with your money running out. In other words, to save enough for your retirement you’re going to have to set aside enough money to provide you with a suitable income for several decades. Think 25 years, maybe even 30.

5. Here’s your answer

You now basically have enough data to make some estimates.

Let’s say you plan to retire at 65 and will need an income of $10,000 a year from your investments and you want to make sure the money will last up to 30 years.  How much will you need to save?

Some people will direct you to the annuities market for some answers. An immediate fixed annuity is a product from an insurance company that will provide you with a guaranteed income for life.

A 65-year-old man who wants an income of $10,000 a year for life could approximate that number and buy an annuity for about $130,000. A 65-year old woman would pay a little more, upwards of $140,000 because the insurance company figures she’ll live longer.

So that’s it, right? You’ll need to save about 13 or 14 times the extra income you need?  Not so fast.

Those annuities won’t protect you from inflation. That problem is a big deal! Over 20 or more years, even modest rates of inflation will hurt you. An inflation rate of 3% will nearly halve your purchasing power. There are, unfortunately, very few annuities which offer inflation protection.

A reasonably conservative investment portfolio, suitable for someone in retirement, can do better.

Think of a portfolio of inflation-protected Treasury bonds, known as TIPS, and high-quality blue-chip stocks. Although both offer lower returns than usual at the moment, most of the time you would expect a portfolio like this to earn an average return of inflation plus about 3% over the course of an economic cycle.

Based on those numbers, you probably need to set aside about 20 times your required annual income by the time you retire.

If you need your portfolio to generate $10,000 a year and last up to 30 years, for example, you’d want to start with about $200,000. If you need your portfolio to generate $50,000 a year, you’d want to start with $1 million.

6. Don’t panic yet

It’s no wonder so few people want to do the math. They haven’t saved anywhere near enough. The most depressing data from each year’s EBRI report are the numbers showing what people have actually saved.

Fewer than one worker in two has even managed to set aside $25,000. Fewer than one in four has reached $100,000—itself only enough to generate $5,000 a year.

Yes, the numbers are slightly better for those who are older and nearer retirement. They’ve had longer to save. But even among them the picture is dismal. Among workers over 45, just 54% have even managed to save $25,000 or more.

Remember, this is after three decades of supernormal investment returns. Stocks boomed through the 1980s and ’90s. Bonds have boomed for 30 years. Future returns from here are highly unlikely to be so favorable.

Those falling short will need to save, save and save even more. The sooner they start, the more likely they are to make it.

The one cheerful caveat: The EBRI numbers do not include the value of people’s homes. If you have a lot of equity in your home, you can convert that into extra savings if you need to, either by selling or by using a cash-out reverse mortgage, which allows you to convert some of your equity into cash.  These mortgages typically involve high fees. But they are, at least, an option.

For those facing a retirement-savings crisis, the strategies for adapting are well known but worth reviewing. They include scaling back, moving somewhere much cheaper and delaying retirement as long as possible, which works multiple levers. It gives you longer to save, it gives your savings longer to grow, it reduces the length of time you will need to live off your savings, and it boosts your Social Security income. Even staying in part-time work can help.

There are no easy answers. But the real problem is that most people still don’t even understand the questions.  The best strategy is to get ahead of this problem now, before it’s too late!

Consult with a financial planner or advisor to evaluate and design strategies specific for your circumstance.  Plan now…Relax later!

The information herein contained does not constitute tax advice.  Any decisions or actions based on tax related information contained herein should not be made without first consulting a CPA or Accountant.

For more information contact Compass Asset Management Group, LLC  at 845.563.0537 or Contact@CompassAMG.com

The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm.  Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.