The purpose of retirement plans such as the 401(k) and Individual Retirement Account (IRA) is to save money for your retirement years. As such, the IRS imposes a penalty of 10 percent for early withdrawals taken from qualified retirement plans before age 59 1/2. Qualified retirement plans include section 401(k) plans, tax-sheltered annuity plans under section 403(b) for employees of public schools or tax-exempt organizations, and individual retirement accounts.
While you should always think carefully about taking money out of your retirement plan before you’ve reached retirement age, there may be times when you need access to those funds. Fortunately, IRS provisions allow a number of exceptions that may be used to avoid the tax penalty.
- 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.
- 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.
- Distributions 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, room and board are qualified higher education expenses. This exception applies to expenses incurred by you, your spouse, children and grandchildren.
- Distributions due to an IRS levy of the qualified plan.
- Distributions that are not more than the cost of your medical insurance. Even if you are under age 59 1/2, you may not have to pay the 10 percent additional tax on distributions during the year that is 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.
- Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty after September 11, 2001 and on or after December 31, 2007.
- Distributions in the form of 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.
- If you have out-of-pocket medical expenses that exceed 7.5 percent of your adjusted gross income, you can withdraw funds from a retirement account to pay those expenses without paying a penalty. For example, if you had an adjusted gross income of $100,000 and medical expenses of $12,500, you could withdraw as much as $5,000 from your pension or IRA without incurring the 10 percent penalty tax. You do not have to itemize your deductions to take advantage of this exception.
- 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 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.
Remember that although using the above techniques 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. Distributions rolled over into another qualified retirement plan or distributions from a Roth IRA, however, escape both the regular income tax and the 10 percent penalty tax. Rollovers should be made directly between your brokers, to avoid paying the 20 percent withholding required on distributions that you touch.
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