Exceptions To The 10% Early Withdrawal Penalty Of Traditional IRAs
Knowing the IRA distribution rules can make a big difference in how much you can keep when taking your retirement IRA’s early.
The general rule is that distributions from a traditional IRA account before ages 59-1/2 will be treated as premature distributions. So if you retire early (before 59-1/2) and withdraw money from your traditional IRA account for necessary living expenses, any distributions will be fully taxable (except for the part of any nondeductible IRA contributions you have made). A 10% penalty tax will also be incurred for distributions made before age 59-1/2.
Good news is that the 10% penalty tax may be avoided in several instances:
Substantially Equal Periodic Payments (SEPPs) are the most universally available way to avoid early distribution penalties (not regular taxes). The tax code IRC section 72(t)(2)(A)(iv) provides an exception to the 10% penalty for distributions that are part of series of equal periodic payments over your life expectancy. The substantially equal periodic payments must be made at least annually until you are at least 59-1/2 or for 5 years, whichever comes later. If you terminate your SEPPs before the later of 59-1/2 or 5 years, you must pay the 10% penalty retroactively on all prior SEPPs distributions.
This option can be useful if you have long-term debt obligations or need funding for early retirement, but are too young to begin to receive pension benefits without penalties. This option has been used when spouses divorce and one party wants to go back to college.
Qualified First-Time Homebuyer Distributions is also not subject to the 10% penalty. If you have not owned a home for the last 2 years, you will be treated as a first-time homebuyer and qualify for a $10,000 ($20,000 for couples) life-time penalty-free exemption for IRA distributions. If the money is used to build or buy the first home of your or your spouse’s child or grandchild, it is also penalty-free.
Medical Expenses payment is also a penalty-free option for early IRA withdrawal. No matter if you itemize or not, you do not need to pay the 10% penalty if your IRA money is used to pay any unreimbursed medical expenses that exceed certain percentage of your adjusted gross income (AGI).
Eligible Higher-Education Expenses incurred at certain educational institutions for you, your spouse or your children or grandchildren are also exempted for the 10% penalty. Eligible expenses include tuition, fees, books and supplies, and possibly room and board (for an at least half-time student).
Medical Insurance Premium While Unemployed under certain circumstances can be paid with early IRA distribution money without paying penalties. First, you have received unemployment compensation for 12 consecutive weeks due to loss of your job. Second, the early distribution needs to be received in the year you receive the compensation or the following year. Third, the distribution must be taken no later than 60 days after you become unemployed.
Death and Disability are the other situations in which IRA early distributions are not subject to the 10% penalty.
Conclusion: Even though the distributions are penalty-free, they will still be subject to federal and state income taxes if they were previously deducted. To claim the early withdrawal penalty exception, you may be required to file IRS Form 5329 along with your tax return unless your IRA custodian reports the amount as being exempted on IRS Form 1099R.
You must begin to take money out of your IRA once you reach 73. There is a 25% penalty tax on what you should have but not have been taken out. IRA distributions can be more complicated than you think. It is critical that you plan ahead for your IRA contribution and distribution plans. Remember to give me a call or set up an appointment if you need help with your retirement planning.
The general rule is that distributions from a traditional IRA account before ages 59-1/2 will be treated as premature distributions. So if you retire early (before 59-1/2) and withdraw money from your traditional IRA account for necessary living expenses, any distributions will be fully taxable (except for the part of any nondeductible IRA contributions you have made). A 10% penalty tax will also be incurred for distributions made before age 59-1/2.
Good news is that the 10% penalty tax may be avoided in several instances:
Substantially Equal Periodic Payments (SEPPs) are the most universally available way to avoid early distribution penalties (not regular taxes). The tax code IRC section 72(t)(2)(A)(iv) provides an exception to the 10% penalty for distributions that are part of series of equal periodic payments over your life expectancy. The substantially equal periodic payments must be made at least annually until you are at least 59-1/2 or for 5 years, whichever comes later. If you terminate your SEPPs before the later of 59-1/2 or 5 years, you must pay the 10% penalty retroactively on all prior SEPPs distributions.
This option can be useful if you have long-term debt obligations or need funding for early retirement, but are too young to begin to receive pension benefits without penalties. This option has been used when spouses divorce and one party wants to go back to college.
Qualified First-Time Homebuyer Distributions is also not subject to the 10% penalty. If you have not owned a home for the last 2 years, you will be treated as a first-time homebuyer and qualify for a $10,000 ($20,000 for couples) life-time penalty-free exemption for IRA distributions. If the money is used to build or buy the first home of your or your spouse’s child or grandchild, it is also penalty-free.
Medical Expenses payment is also a penalty-free option for early IRA withdrawal. No matter if you itemize or not, you do not need to pay the 10% penalty if your IRA money is used to pay any unreimbursed medical expenses that exceed certain percentage of your adjusted gross income (AGI).
Eligible Higher-Education Expenses incurred at certain educational institutions for you, your spouse or your children or grandchildren are also exempted for the 10% penalty. Eligible expenses include tuition, fees, books and supplies, and possibly room and board (for an at least half-time student).
Medical Insurance Premium While Unemployed under certain circumstances can be paid with early IRA distribution money without paying penalties. First, you have received unemployment compensation for 12 consecutive weeks due to loss of your job. Second, the early distribution needs to be received in the year you receive the compensation or the following year. Third, the distribution must be taken no later than 60 days after you become unemployed.
Death and Disability are the other situations in which IRA early distributions are not subject to the 10% penalty.
Conclusion: Even though the distributions are penalty-free, they will still be subject to federal and state income taxes if they were previously deducted. To claim the early withdrawal penalty exception, you may be required to file IRS Form 5329 along with your tax return unless your IRA custodian reports the amount as being exempted on IRS Form 1099R.
You must begin to take money out of your IRA once you reach 73. There is a 25% penalty tax on what you should have but not have been taken out. IRA distributions can be more complicated than you think. It is critical that you plan ahead for your IRA contribution and distribution plans. Remember to give me a call or set up an appointment if you need help with your retirement planning.