Freeing up money during tough times
A lot of people are thinking of tapping their retirement funds early. Make sure you know the rules before you do.
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| Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005). |
NEW YORK (Money) -- Question: I'm 57 and my wife is 62, and we're thinking of selling some of our IRA assets to get through these tough times. But will we be hit with a penalty if we do? --Dave, Gainesville, Florida
Answer: I normally counsel people to avoid tapping their retirement stash before they actually retire. After all, you'll be counting on that dough in large part to support you throughout the 30 or more years could easily live after the paychecks stop rolling in. So the longer you can keep your hands off your IRA and other retirement assets, the more likely that money will be there when you need it later in retirement.
But if you've run out of other options - like tapping an emergency fund or other non-retirement investments - you may have little choice but to dip into your IRA sooner than you'd like. It sounds like this may be the situation you and your wife now face.
Given the decline in stock values over the last year and the number of layoffs since this recession began, I'm sure that many other people are finding themselves in a similar position.
So while I certainly don't want to encourage anyone to begin yanking money from his or her retirement accounts prematurely, now is a good time for a quick review of the rules for getting your money out of an IRA, as well as some tips for how you might best handle your situation.
When you pull money from an IRA account, you will owe income taxes at ordinary income rates on the taxable portion of the withdrawal. I say "taxable portion" because it's possible (though I think for most people not very likely) that some of the withdrawal won't be taxed.
For example, if you made nondeductible contributions to an IRA - or, for that matter, contributed after-tax dollars to a 401(k) and then rolled the balance into an IRA - then the nondeductible or after-tax dollars you contributed won't be taxed again at withdrawal. In such a case, the IRS's pro rata rule stipulates that each withdrawal consists of a proportionate amount of taxable and nontaxable dollars, and you owe tax only on the taxable portion.
But if you never made nondeductible contributions to an IRA or after-tax contributions to a 401(k) that you later rolled into an IRA, then the entire amount of your IRA withdrawals would be taxable.
If you're under age 59 ½ when you pull money from your IRA, the same rules I described above apply, with one major addition: you'll not only owe income tax on the taxable portion of the withdrawal, but a 10% early withdrawal penalty as well.
You may, however, be able to avoid the extra charge if you qualify for one of the exceptions to the early-withdrawal penalty. For example, you can withdraw funds penalty-free from an IRA if you're disabled, you lose your job and need the money for health insurance or if you use the funds to pay unreimbursed medical expenses greater than 7.5% of your adjusted gross income. Distributions for qualified education expenses are also exempt from the penalty, as are withdrawals of up to $10,000 to buy a first-home.
Then there's the 72(t) annuity exemption, which allows you to sidestep the 10% penalty if you withdraw "substantially equal periodic payments" based primarily on life expectancy. To see how much you can withdraw under this rule, you can consult a 72 (t) calculator, many of which are available online. One big caveat, though: Once you begin taking such payments, you must continue for five years or until you're 59 ½, whichever takes longer.
For details on these and a few other penalty exemptions, check out IRS Publication 590: Individual Retirement Arrangements.
Now let's back to you and your wife. Given these IRA withdrawal rules, the obvious course is for you to take whatever money you need from her IRA, since she's older than 59 ½. That way, you pay only tax, avoid any penalty and you don't have to worry about qualifying for exemptions.
If it turns out you need more dough than she has in her IRA, you can then turn to your IRA. By that time, maybe you'll also be 59 ½ and you won't have to worry about paying the penalty either. If that's not the case, you can at least see whether you qualify for any of the exceptions to the penalty rule.
There's one other strategy you might want to consider, however. If you currently need money to cover expenses that would qualify for one of the exemptions, say, unreimbursed medical expenses, you could tap your IRA instead of your wife's to cover that cost. That would leave more money in your wife's IRA in case you later need cash for situations that aren't covered by an exemption.
Hopefully, you and your wife will be able to get through this period without drawing so much from your IRAs that you jeopardize your retirement security. But whatever amount you end up pulling out, at least try to do it in a way that avoids that 10% penalty. No sense in giving back more of your stash to the IRS than you absolutely have to. 
