Q: I have $18,000 in an IRA money market account. It was half of my ex-husband's IRA that was transferred to me via judge's orders. If I take a few thousand out, do I have to pay taxes on it?
A: This is a complex situation with several variables, so you would be wise to consult a tax expert with the particulars. However, the following are some of the key issues in play:
- Your age. The critical number here is 59 1/2 -- and older is better. If you are younger than 59 1/2, most likely you would incur a 10 percent penalty on any distribution from the IRA, on top of any ordinary tax liability the distribution would trigger. That extra penalty is so onerous that most experts advise against taking early distributions from an IRA. So, if you are younger than 59 1/2, you might want to stop right here and decide to leave the money in the IRA, keeping in mind that you can change investment vehicles while keeping the money in an IRA if the money market account is not meeting your needs.
- The type of IRA. There are two types of IRAs: Roth and traditional. On a Roth IRA, tax has already been paid on the contributions, so you would just owe tax on any investment earnings in the plan when those earnings are distributed (i.e., withdrawn from the IRA). In a traditional IRA, the entire amount of the distribution is treated as income for tax purposes.
- How long the plan has been set up. If it is a Roth IRA and you have had it for less than five years, you may incur the 10 percent early distribution penalty if you make withdrawals before the account's five-year anniversary.
- Cost basis. If the account is a traditional IRA, cost basis should not be an issue, since there is no distinction between prior contributions and investment earnings. In a Roth IRA though, that distinction matters, and you might want to consult with a tax expert to determine the cost basis because the transfer from your husband could complicate that.
The biggest factor here is whether you are older than 59 1/2, because if you are younger than that you could be incurring both taxes and a penalty. However, whether this is a Roth or a traditional IRA is also critical, because it determines whether taxes have already been paid on the original contributions to the account. In that context, it would seem that a Roth IRA would have more long-term economic value than a traditional IRA as part of a divorce settlement, because the traditional IRA would carry a bigger future tax liability.
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