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SIMPLE IRAs: Distributions
Distributions from SIMPLE IRAs must occur eventually, but some distributions are elective while others are forced. The tax and penalty treatment of distributions are determined by the SIMPLE IRA owner's age at the time of distribution.
Two-Year Rule
During the first two years after the SIMPLE IRA is established, assets held in the SIMPLE IRA must not be transferred or rolled to another retirement plan. This two-year period begins the first day the employer deposits a contribution to the SIMPLE IRA. After the two-year period, assets in a SIMPLE IRA may be moved to another eligible retirement plan by means of a transfer, rollover (including a direct rollover) or as a Roth conversion.
The two-year waiting period does not apply to transfers or rollovers between two SIMPLE IRAs.
Distributions that occur during the two-year period are subjected to an early-distribution penalty of 25% if the SIMPLE IRA owner is under age 59.5 when the distribution occurs. If an exception applies, however, the 25% penalty is waived. Distributions that occur when the SIMPLE IRA holder is age 59.5 or older are not subjected to the early-distribution penalty, even if the distribution occurs within the two-year period.
Distributions that Occur Before Age 59.5
Distributions that occur before the individual reaches the age of 59.5 are subjected to a 10% early-distribution penalty. For SIMPLE IRAs, this 10% penalty is increased to 25% if the individual receives a distribution within two years of the first contribution made to his or her SIMPLE IRA account. The 10% penalty is in addition to any income tax owed on the amount. There are certain instances where the IRS will waive the early-distribution penalty and the 25% penalty for distributions that occur during the two-year period. The IRS waives the penalty when distributions are used for the following reasons:
For un-reimbursed medical expenses
If the distribution is used to pay un-reimbursed medical expenses, the amount that exceeds 7.5% of the individual's adjusted gross income (AGI) for the year of the distribution will not be subjected to the early-distribution penalty. In other words, the amount paid for the un-reimbursed medical expenses minus 7.5% of the individual's adjusted gross income for the year of the distribution can be distributed penalty free.
Example 1
Jack's AGI is $25,000, and he paid $4,000 for un-reimbursed medical expenses.
The amount that exceeds 7.5% of his income = $4,000 - ($25,000 x 7.5%).
The amount that exceeds 7.5% of his income = $4,000 - $1875.
The amount that exceeds 7.5% of his income = $2,125.
The maximum amount Jack may claim for the early-distribution exception is $2,125. |
To pay medical insurance
Individuals can make a penalty-free distribution to pay medical insurance for themselves, their spouses, and dependents, providing the distribution occurs under the following four conditions:
- The individual has lost his or her job.
- The individual has received unemployment compensation paid under any federal or state law for 12 consecutive weeks.
- The individual receives the distributions during either the year he or she receives the unemployment compensation or the following year.
- The individual receives the distributions no later than 60 days after he or she has been re-employed.
For a disability
If an individual becomes disabled before age 59.5 and makes a distribution from his or her Traditional IRA because of the disability, the distributions are not subjected to the early-distribution penalty. Individuals are considered disabled if they furnish proof that a physical or mental condition inhibits them from engaging in substantial gainful activities. A physician must determine that this condition can be expected to result in death or to continue for an indefinite duration.
As distributions to the IRA beneficiary
If the IRA owner dies before reaching age 59.5, the amounts distributed from the IRA by the designated beneficiary are not subject to penalty.
As part of a SEPP program
For penalty-free distributions that are part of a series of substantially equal payments over the life of the IRA holder and or his/her beneficiary, the payments must last five years or until the IRA owner reaches age 59.5 - whichever is longer - and the payments must also follow certain IRS-approved methods.
For qualified higher-education expenses
Amounts are penalty free if they must go towards qualified higher-education expenses of the IRA owner and/or his or her dependents. These qualified education expenses are tuition, fees, books, supplies and equipment required for the enrollment or attendance of a student at an eligible educational institution. An eligible educational institution is any college, university, vocational school or other post-secondary educational institution eligible to participate in the student aid programs administered by the Department of Education. These eligible educational institutions include virtually all accredited post-secondary institutions, whether public, nonprofit or proprietary (privately owned and profit making). The educational institution should be able to indicate if it is an eligible educational institution.
To purchase a first home
The IRA owner can make penalty-free distributions to purchase, build or rebuild a first home:
- for the IRA owner
- for the IRA owner's spouse
- for a child of the IRA owner or of the IRA owner's spouse
- for a grandchild of the IRA owner or of the IRA owner's spouse
- for a parent or other ancestor of the IRA owner or of the IRA owner's spouse
The first-time homebuyer distribution must be used to pay qualified acquisition costs before the end of the 120th day after the IRA owner receives the distributed assets.
The total distribution the IRA owner uses for first-time home purchases cannot exceed $10,000 during the IRA owner's lifetime. For married individuals, the $10,000 applies separately to each spouse, which means that the total for both is $20,000.
For payment of an IRS levy
The IRS may levy against an IRA, resulting in a distribution. The distributed amount is subjected to income tax, but the early-distribution penalty is waived. |
Additional Information
The early-distribution penalty does not apply to amounts that are not subjected to income tax. These include amounts that were contributed in excess of the contribution limit and are then removed from the SIMPLE IRA before the owner's tax-filing deadline (plus tax-filing extensions); other distributions not subjected to income tax are those that occur after the two-year period and are later deposited to an eligible retirement plan as a rollover contribution within 60 days of receipt.
Distributions that Occur on or After Age 59.5
Distributions that occur on or after the SIMPLE IRA owner reaches age 59.5 may be subject to income tax, but will not be subjected to any early-distribution penalty. These distributions are also subjected to the two-year rule and cannot be rolled over to an eligible plan during the first two years after the SIMPLE IRA is established.
Required Minimum Distributions
Traditional IRA distributions cannot be deferred indefinitely. An IRA owner must begin required minimum distributions (RMDs) the year he or she reaches age 70.5, at which time the IRA owner may distribute the full balance of the IRA or distribute a minimum amount each year.
The first RMD must be distributed by Apr 1 of the year after the IRA owner reaches age 70.5. For example, an IRA owner who reaches age 70.5 in June of 2007, must take his or her first RMD by Apr 1, 2008. IRA holders who elect to have a minimum amount distributed each year must, for subsequent years, distribute RMDs by Dec 31 of each year. This means that if the IRA holder defers the first RMD until Apr 1 of the next year after he or she turned 70.5, he or she will be required to take a second RMD amount in this next year, which counts as the second year of the RMD.
Example 2
Jill turns 70.5 in June of 2007, and she decides to defer her first RMD until Apr 1, 2008.
Jill is required to take a second RMD (for 2008) by Dec 31, 2008. For subsequent years, Jill must distribute her RMD amounts by Dec 31 of each year. |
Generally, the IRA custodian/trustee will calculate the RMD amount and send the notification to the IRA holder. Alternatively, the IRS custodian/trustee may send a RMD reminder to the IRA holder with an offer to calculate the RMD amount upon request.
RMD amounts not distributed from the IRA by the due date are subjected to a 50% excess-accumulation penalty.
Example 3
John is 75 years old, and his RMD for 2007 is $5,000. But by Dec 31, 2007, John distributed only $4,000. Because John's RMD was short by $1,000, he must pay the IRS a 50% excess-accumulation penalty ($1,000 x 50% = $500). |
The excess-accumulation penalty must be paid when the individual files his or her federal tax return. If the individual feels that the failure was due to reasonable circumstance, he or she may write to the IRS and request that the penalty be waived. If the request is approved, the amount is returned to the individual.
Next: SIMPLE IRAs: Conclusion
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