taxes

401(k) withdrawal rules can be tricky

George SaenzQuestionDear Tax Talk,
I rolled over money from an employer-sponsored 401(k) plan to an IRA in 2007. I retired in 2006 as my company merged and relocated. Early this year, I withdrew funds for a down payment on a home. I qualify for the $10,000 for first-time homebuyer as it relates to not having the 10 percent tax penalty. Since I was over 55 when the withdrawal occurred and I had service separation from my company, am I exempt completely from a 10 percent tax withdrawal penalty?
-- A. Johnson

AnswerDear A. Johnson,
As a first-time homebuyer, you can make a penalty-free withdrawal from your IRA to use toward the purchase including closing costs of a home, provided you have not owned a principal residence within two years on the date of acquisition of the new property. The funds must be used to acquire the home within 120 days from their withdrawal. The date of acquisition is considered the date that you enter into a binding contract to buy the new home, not the date of closing.

When an individual retires or otherwise leaves his employer in or after the year they turn age 55, he or she can make penalty-free withdrawals from his employer-sponsored retirement plan. This is referred to as the separation from service exception. The withdrawal can be a complete or partial distribution, and there is no requirement to receive further distributions. This exception would be advantageous if you plan to start your own business or cover other needs.

Unfortunately, once you rolled the funds out of your employer's plan and into an IRA, you lost your ability to use the separation from service exception to avoid the 10 percent penalty. The exception to the penalty does not apply to IRA withdrawals, even though the IRA is composed entirely of the employer-sponsored retirement plan assets.

While many investment companies tout the idea of rolling over your former employer's retirement plan accounts, if you're over age 55 when you separate from service, you need to consider this limitation.

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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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