Most distributions from 401(k) plans and IRAs are subject to a 10% early withdrawal penalty if they are taken before you reach age 59 ½. However, like most tax rules, there are certain exceptions allowing you to withdraw funds without a penalty. This blog will address the most common exceptions to the 10% additional tax on early withdrawals.
Deferring money to retirement savings plans offered by employers is a great way for Americans to save for their golden years. And, though in this blog we outline reasons the early withdrawal penalties are waived, we recommend this as a last resort. Talk to your tax and financial advisors before withdrawing any funds.
Distributions from 401(k) plans and IRAs are exempt from the early withdrawal penalty if rolled over into another eligible retirement plan within 60 days.
Distributions Made to Beneficiaries
401(k) and IRA distributions made to beneficiaries of plans inherited after death are generally not subject to the early withdrawal penalty. However, if a spouse beneficiary chooses to treat an IRA as his or her own and is under age 59 ½, distributions will be subject to the 10% penalty. The penalty does not apply if the spouse takes the distribution as the IRA beneficiary, rather than the IRA owner.
Disabled persons can take distributions from both 401(k) plans and IRAs without being subject to the early withdrawal penalty. A disabled individual, for this purpose, is one that is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”
The IRS requires proof of disability for this penalty exemption. Substantiating documentation from a physician should be obtained.
Distributions from both IRAs and 401(k) plans used to pay for medical expenses not reimbursed by health insurance that exceed 10% of your adjusted gross income are not subject to the early withdrawal penalty.
Health Insurance Premiums (IRA only)
Withdrawals from IRAs used to pay health insurance premiums while unemployed are exempt from the 10% penalty if all the below requirements are met.
Unemployment compensation is received for at least 12 consecutive weeks.
The withdrawal is made the year unemployment compensation is received or the subsequent year.
The withdrawal must be made prior to 60 days of employment at a new job.
Higher Education Expenses (IRA only)
Withdrawals from IRAs for qualified higher education expenses for you, your spouse, child, or grandchild are exempt from the early withdrawal penalty. The distribution can’t exceed the qualified higher education expenses incurred during the tax year. Qualified higher education expenses include tuition at a postsecondary school, room and board (if enrolled at least half-time), fees, books, supplies, and equipment required for enrollment or attendance.
First-Time Home Purchases (IRA only)
You may withdraw up to $10,000 from your IRA during your lifetime to pay qualified acquisition costs for a principal residence without being subject to the 10% penalty if you meet the IRS definition of a “first-time homebuyer”. You are considered a first-time homebuyer if you have not owned a home in the two years preceding the purchase or your principal residence (if married, your spouse must also meet this requirement). This exception applies to costs to purchase your and/or your spouse’s home or a home for your child, grandchild, parent, or grandparent if you or they qualify as a first-time homebuyer. The funds withdrawn from the IRA must be used to pay the acquisition costs by the 120th day after the distribution is received.
The rules regarding early distributions from your retirement plan can be complex. A comprehensive chart of exceptions to the penalty can be found here on the IRS website. Call on us to discuss your options before you take a distribution and we will work through the details to assist you in determining if your distribution will be subject to the early withdrawal penalty.