The contributions you make to your IRA are intended to supplement your income during your retirement years. However, as much as you would like to let your IRAs remain untouched until retirement, unforeseen expenses may force you to distribute some of those assets prematurely.
Should you decide to take a distribution from your IRA, these amounts may be subject to federal and state taxes. What’s more, if you are under the age of 59½ when the distribution occurs, you may be assessed an additional 10% early-distribution penalty on any taxable amount. The IRS imposes this penalty to deter individuals from taking premature distributions from their retirement accounts. Fortunately, it also provides exceptions under which the penalty may be waived. Here are the circumstances under which the IRS will waive this early-distribution penalty. (See: Traditional IRAs: Distributions.)
1. Unreimbursed Medical Expenses
If you do not have health insurance or your medical expenses are more than your insurance will cover for the year, you may be able to take penalty-free distributions from your IRA to cover these expenses. Note, however, that only the difference between these expenses and 10% (7.5% if you were born before January 2, 1952) of your adjusted gross income (AGI) is eligible for this exception. For example, if your adjusted gross income is $100,000 and your un-reimbursed medical expenses are $10,000, the maximum amount that you can distribute penalty free is $2,500, which is the difference between $10,000 and 7.5% of your AGI ($7,500). Your tax professional should be able to help you determine your AGI.
2. Medical Insurance
If you are unemployed, you may take penalty-free distributions from your IRA to pay for your medical insurance. In order for the distribution amount to be eligible for the penalty-free treatment, you must meet these certain conditions:
- You lost your job.
- You received unemployment compensation paid under any federal or state law for 12 consecutive weeks.
- You received the distributions during either the year you received the unemployment compensation or the following year.
- You received the distributions no later than 60 days after you were re-employed.
If a physician determines that, because of a mental or physical disability, you are unable to engage in any gainful employment, you are allowed to take penalty-free distributions from your IRA. Also, the disability must be expected to result in your death or be determined to last for an indefinite period. These distributions can be taken for any purpose. Check with your IRA custodian/trustee regarding its policy for handling distributions due to disability, as some require proof of disability in the form of a physician’s certification. (You can also insure yourself in case of disability.) See: Intro to Insurance: Disability Insurance.
4. Higher-Education Expenses
If you need to pay expenses for higher education for you, your spouse or your children or grandchildren, you may be able to take penalty-free distributions to do so. Only expenses incurred at certain educational institutions, such as a college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the U.S. Department of Education are eligible. For this purpose, eligible educational expenses include items such as tuition, fees, books and supplies. Be sure to consult with your tax professional to determine whether your expenses qualify. Also consult with the educational institution to determine whether it satisfies the requirements to be part of the program.
5. Inherited IRA Assets
If you are the beneficiary of a deceased person’s IRA, amounts you distribute from the inherited IRA are not subjected to early-distribution penalties. This exception does not apply if you are the spouse-beneficiary of the decedent and decide to transfer or roll over the amount to your own non-inherited IRA. To ensure that the IRS knows that the amount is not subject to the early-distribution penalty, your IRA custodian/trustee should report the withdrawn amounts as death distributions by including ‘Code 4’ in box 7 of the IRS Form 1099-R that is used to report the distribution. Check with your IRA custodian/trustee regarding the documentation requirement for processing your transaction. (For more see: Distribution Rules for Inherited Retirement Plan Assets.)
“In the case of a deceased IRA owner who has been withdrawing required minimum distributions (RMDs), the beneficiary will be required to continue the same RMD schedule until the end of that calendar year. If not, the IRS will impose an excise tax – a 50% penalty. Thereafter, you calculate your distributions on your life expectancy,” says Rebecca Dawson, a financial advisor in Los Angeles, Calif.
6. Home Purchases
If you are purchasing, building or rebuilding a first home, the IRS allows you a penalty-free distribution of up to $10,000 to use toward your expenses, including closing costs. The IRS sees your home as a first-time home if you have not owned a home for the past two years. This $10,000 is a lifetime limit. If you are married, your spouse is entitled to an additional $10,000 from his/her account. For this purpose, eligible individuals include your spouse or your or your spouse’s child, grandchild and parent or other ancestor.
7. Substantially Equal Periodic Payments
If you need to take money from your IRA for a few years, the IRS allows you to do so penalty free if you meet certain requirements. Basically, the same amount – determined under one of three IRS-pre approved methods – must be taken until you are either age 59½ or for five years, whichever comes later. This is referred to as taking substantially equal periodic payments (SEPPs) from your IRA.
“This is often overlooked. In fact, I have worked with clients’ tax advisors to help them mitigate the impact of taxes,” says Marguerita M. Cheng, CFP®, CEO of Blue Ocean Global Wealth, Gaithersburg, Md. The rules regarding SEPPs are relatively complex. If you are considering taking SEPPs from your IRA, we strongly recommend you seek competent tax advice. (For more, see Substantially Equal Periodic Payment (SEPP): Learn the Rules.)
8. IRS Levy
The 10% penalty normally charged for an IRA withdrawal is waived for amounts withdrawn from your IRA as a result of an IRS levy. However, the exception does not apply if you voluntarily withdraw the amount from your IRA to pay the taxes owed in order to avoid the levy.
9. A Call to Active Duty
Qualified reservist distributions are not subject to the 10% penalty. For this purpose, a qualified reservist distribution has to meet the following requirements:
- It was distributed from an IRA or attributable to elective deferrals under a 401(k) plan or 403(b) account.
- It was distributed to a member of the reserves who is called to active duty for a period in excess of 179 days or for an indefinite period.
- It was distributed during the period beginning on the date the reservist was called to active duty and ending at the close of the active duty period.
- It was distributed by individuals ordered or called to active duty after September 11, 2001.
The Bottom Line
Even though amounts distributed for the above reasons are exempt from the early-distribution penalty, they may still be subject to federal and state tax. Your tax professional should be able to determine which amounts may be taxable and help ensure that the appropriate forms are filed.
To claim the early-distribution penalty exception, you may be required to file IRS Form 5329 along with your income tax return, unless your IRA custodian reports the amount as being exempted on IRS Form 1099-R. (See also: Retirement Plan Tax Form 5329: When to File.)