March 13, 2017
There is a general 10% early withdrawal penalty if you make withdrawals from your Traditional Individual Retirement Account (IRA) before reaching age 59 ½. In addition to the 10% penalty, you will also have to pay income tax on the withdrawal. If you are in a 25% federal tax bracket, and live in a state with a 5% income tax, this means you could be paying a total of 40% taxes and penalties on your withdrawal – ouch!
Before trying to qualify for a penalty exception, take a hard look at your financial situation to make sure that you absolutely have to withdraw from your IRA. Besides providing up-front tax deductions for contributions, an IRA defers taxes on income until you retire and withdraw the funds. Taking IRA distributions early not only subjects you to tax and potential penalties, but it also robs you of tax-deferred growth of this important retirement asset. Some potentially preferable sources of funds could include taking a loan from your 401(k) account, taking a withdrawal from your 401(k) account (where the age limit is only 55 if you are retired), drawing tax-free principal from a Roth IRA, obtaining a home equity loan, and borrowing from friends and family.
If you must withdraw your IRA balance, try to satisfy one of these exceptions to avoid the 10% penalty tax:
1) College Expenses
Use the funds for higher education for yourself, your spouse, and the children or grandchildren of you or your spouse. The funds that you withdraw need to be used for qualified expenses for this exemption, including tuition, fees, books, and required supplies. There are also eligibility criteria for the educational institution. Keep in mind that the IRA withdrawal will increase your federal taxable income, and could decrease your eligibility for financial aid.
2) First Time Home Purchase
If you or your spouse did not own a home during the two-year period before a home purchase, you may qualify as a “first time” homebuyer, and could be eligible for a $10,000 penalty exception ($20,000 for a couple) for IRA funds used to buy or build your home. This dollar limit is a lifetime amount, so if you claimed this exemption in the past, your eligibility could be reduced or eliminated. You also must use the IRA distribution funds within 120 days of making the withdrawal in order to qualify for this exception. Costs to buy or build the home of a child, grandchild, or parent may also qualify if you meet the criteria.
3) Medical Expenses
If your medical expenses exceed 10% of your Adjusted Gross Income, you can use an IRA distribution to fund these expenses and avoid the tax penalty.
4) Health Insurance
If you have been unemployed and receiving unemployment compensation for at least 12 consecutive weeks, you may be eligible to use IRA distributions to pay for health insurance for you, your spouse, and your dependents.
5) Disability
If you are disabled and unable to be gainfully employed, you may be eligible for an exemption to the early withdrawal penalties. Due to the subjective nature of this exception, it is imperative to properly document the disability and consult with appropriate physicians.
6) Wait until you are 59 ½
If you are close to qualifying retirement age, try to wait before making an IRA withdrawal. Once you are 59 ½, distributions are not considered “early”, and are not subject to the 10% penalty.
7) Set up “Substantially Equal Periodic Payments”
If you set up a plan to make distributions as part of a series of substantially equal periodic payments over your life expectancy (based on IRS tables), these distributions are not subject to the early withdrawal penalty. Be careful of modifying this distribution schedule later on – you can be subject to the penalty and interest if you stray from the approved schedule.
8) Qualifying Military Service
If you are a military reservist called up for active duty, you may be eligible for an exemption to the early withdrawal penalty. There are strict rules about the period of service, and you must take the distribution during your tour of active duty – so make sure you qualify for all relevant aspects of this exemption.
9) Inherited IRA
IRA’s that are inherited are not subject to the same retirement age distribution rules. In fact, there are requirements for how quickly the IRA must be paid out during the beneficiary’s lifetime. The early withdrawal penalty generally doesn’t apply to inherited IRAs, unless it was your spouse’s IRA, you elected to treat it as your own, and you haven’t yet reached age 59 1/2.
This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation. Please consult your tax advisor for any specifics on these ideas – there are many nuances and issues that have not been fully elaborated in this article.
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