Many people use IRAs, SEP Plans, SIMPLE IRA plans, and employee-sponsored retirement savings plans such as the 401(k) to save money for their retirement years, but what if you need to tap that money before age 59 1/2? The bad news is that you generally have to pay a 10 percent penalty for early withdrawal of your funds. While that may seem unfair (after all, most of it is probably your money), you need to remember that the purpose of these types of plans is to save money for the years when you are no longer working.
Sometimes, however, life intervenes, and there may be times when you need access to those funds before you’ve reached retirement age. The good news is that under IRS rules you may be able to use one of the following exceptions to avoid paying the tax penalty. However, you need to remember that although the exceptions listed below will help you avoid the 10 percent penalty tax, you are still liable for any regular income tax that’s owed on the funds that you’ve withdrawn.
1. Death of the Participant/IRA Owner. If you are the beneficiary of a deceased IRA owner, you do not have to pay the 10 percent penalty on distributions taken before age 59 1/2 unless you inherit a traditional IRA from your deceased spouse and elect to treat it as your own. In this case, any distribution you later receive before you reach age 59 1/2 may be subject to the 10 percent additional tax.
2. Total and Permanent Disability. Distributions made because you are totally and permanently disabled are exempt from the early withdrawal penalty. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.
3. Higher Education Expenses. Distributions from IRAs, SEP Plans, and SIMPLE IRA Plans that are used for qualified higher education expenses are also exempt, provided they are not paid through tax-free distributions from a Coverdell education savings account, scholarships and fellowships, Pell grants, employer-provided educational assistance, and Veterans’ educational assistance. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution, as well as expenses incurred by special needs students in connection with their enrollment or attendance. If the individual is at least a half-time student, then room and board are considered qualified higher education expenses. This exception applies to expenses incurred by you, your spouse, children and grandchildren.
Caution: Early distributions from employee-sponsored retirement plans such as 401(k)s are not exempt from the 10 percent penalty if used for higher education expenses.
4. IRS Levy. Distributions due to an IRS levy of the qualified plan are exempt from the 10 percent penalty.
5. Healthcare Premiums. Even if you are under age 59 1/2, you may not have to pay the 10 percent additional tax on any distributions during the year that are not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply: you lost your job, you received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job, you receive the distributions during either the year you received the unemployment compensation or the following year, you receive the distributions no later than 60 days after you have been reemployed.
Caution: Early distributions from employee-sponsored retirement plans such as 401(k)s are not exempt from the 10 percent penalty if used for healthcare premiums.
6. Military Reservists called to Active Duty. Generally, these are distributions made to individuals called to active duty after September 11, 2001, and on or after December 31, 2007.
7. Equal Payments. Similar to an annuity, you can take the money as part of a series of substantially equal periodic payments over your estimated lifespan or the joint lives of you and your designated beneficiary. These payments must be made at least annually, and payments are based on IRS life expectancy tables. If payments are from a qualified employee plan, they must begin after you have left the job. The payments must be made at least once each year until age 59 1/2, or for five years, whichever period is longer.
8. Medical Expenses. If you have out-of-pocket medical expenses that exceed 10 percent of your adjusted gross income, you can withdraw funds from a retirement account to pay those expenses without paying the penalty. For example, if you had an adjusted gross income of $100,000 for tax year 2019 and medical expenses of $12,500, you could withdraw as much as $2,500 from your pension or IRA without incurring the 10 percent penalty tax.
9. First-time Homebuyers (up to $10,000). An IRA distribution used to buy, build, or rebuild a first home also escapes the penalty; however, you need to understand the government’s definition of a “first time” home buyer. In this case, it’s defined as someone who hasn’t owned a home for the last two years prior to the date of the new acquisition. You could have owned five prior houses, but if you haven’t owned one in at least two years, you qualify.
The first time homeowner can be yourself, your spouse, your or your spouse’s child or grandchild, parent or another ancestor. The “date of acquisition” is the day you sign the contract for the purchase of an existing house or the day construction of your new principal residence begins. The amount withdrawn for the purchase of a home must be used within 120 days of withdrawal and the maximum lifetime withdrawal exemption is $10,000. If both you and your spouse are first-time home buyers, each of you can receive distributions up to $10,000 for a first home without having to pay the 10 percent penalty.
Caution: First-time homebuyers are not exempt from the 10 percent penalty for early withdrawals of funds from employee-sponsored retirement plans such as 401(k)s.
If you are thinking about tapping your retirement money early, call and speak to a trusted tax adviser first.