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Heed Rules in Taking IRA Funds


Q. Two years after being forced to take an early retirement, I find I could really use some of my individual retirement account funds to cover my living expenses. The only problem is that I am 57 years old. I understand that there is some provision in the tax code permitting taxpayers under age 59 1/2 to make early withdrawals without penalty. Can you explain the rules? --J.P .

A. Able-bodied taxpayers under age 59 1/2 are permitted to withdraw funds from their IRAs without penalty if the disbursements are made under one of three annuity-type formulas approved by the Internal Revenue Service. Although no penalty will be imposed for early withdrawal, the funds will still be subject to ordinary income tax unless they consist of after-tax contributions. Disabled taxpayers are entitled to make early withdrawals without penalty under a different, more lenient set of rules.

Taxpayers who make early withdrawals must take disbursements, at the rate determined by the formula of their choosing, for either five years or until reaching age 59 1/2, whichever occurs later. The withdrawal formula cannot change until the minimum period has been completed. In your case, this would mean you would have to take disbursements for at least five years. After that point, you could change the withdrawal amount or discontinue payments without penalty.

What are the disbursement formulas? First is the simple life expectancy method, which is the easiest to calculate but generally provides smaller annual payments than the other methods:

You calculate the annual withdrawal by dividing your account balance by your life expectancy, as determined by IRS actuarial tables. (You may also use your life expectancy and that of your IRA beneficiary, although this would give you an even lower annual withdrawal.) The IRS life expectancy tables are detailed in IRS Publication No. 939.

The second method is often referred to as the amortization method because you amortize your account balance like a mortgage, using one of the life expectancy tables mentioned above plus a long-term interest rate deemed appropriate by the IRS.

In private rulings, the IRS has approved the use of interest rates based on certain prevailing market conditions. Under this system, your annual withdrawal will be higher than under the life expectancy method because the balance is increased each year by the selected interest rate.

The third method is similar to the amortization formula but allows taxpayers to use insurance mortality tables, which project shorter life expectancy than the IRS tables. The result is a higher annual disbursement than for either of the above formulas.

One last note: If you decide to use either the second or third formula, you would be wise to consult a tax professional to make sure your disbursements qualify for the penalty exception.

Calculating Cost Basis of Inherited Stocks

Q. My uncle died, leaving us some stocks. What is the cost basis of those shares? Some people tell us it is their fair market value on the date of his death; others say they can be valued at any point within six months after his death. --W.L.W .

A. If no estate taxes are due, assets are generally valued as of the date of death. However, if taxes are due, the estate executor may value the assets as of the date of death, as of six months after the death or as of the date of sale of any of the assets in the estate if the sale occurs within six months of the death. The selection, which covers all the assets in an estate, must be made upon the filing of the estate tax return, which is generally due nine months after the death.

Heir Can Escape Tax Liability on Home

Q. I own my home and want to leave it to my girlfriend, who has been taking care of me in what I think may be my final days. I have never used the $125,000 profit exemption on a home sale. I am thinking of entering into a sales agreement with her that says she has paid me $140,000 for the home in order to establish that as her cost basis. The grant deed turning the house over to her will be filed upon my death. Will the trustee of my living trust be able to claim the $125,000 deduction on my home sale profit under this arrangement? --M.R.S .

A. Our experts believe you are going to a lot of trouble to achieve your ends, which essentially are to give your girlfriend your home upon your death without sticking her with a huge potential capital gain upon its sale. Rather than the convoluted scheme you propose, why not just leave the home to her in your will? The value of the house will be reset as of your date of death, so she will not be getting an appreciated asset on which there will be unpaid tax. So what if you die without ever having used your $125,000 deduction? There could be worse things left undone at death.

Another alternative would be to "sell" your girlfriend the home with no money down right now. You could use your $125,000 exemption, and in your will you could forgive your girlfriend the unpaid balance. If your estate is valued at less than $600,000, there will be no estate taxes due the government.

Giving Without Gift Tax Consequences

Q. I am confused about how much money a couple can give to their son and his spouse without triggering gift tax consequences. F.F .

A. You and your wife may each give $10,000 per year to as many people as you want without gift tax consequences. Under these limits, you and your wife could give your son and his wife a total of $40,000 per year--$10,000 from each of you to each of them.

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