For one reason or another, you may need to take some money out of an IRA before reaching retirement. You can withdraw money from an IRA at any time and for any reason, but it’s important to keep in mind that most IRA withdrawals are at least partially taxable. In other words, you’ll owe regular income tax on the amount. In addition, the taxable portion of a withdrawal taken before age 59 1/2, which is called an “early withdrawal,” will be hit with a 10% penalty — unless you qualify for an exception.
The exceptions apply to traditional IRAs, SEP-IRAs and SIMPLE-IRAs. (However, some early withdrawals from SIMPLE-IRAs are hit with a 25% penalty rather than the standard 10% penalty. For simplicity, the rest of this article will ignore that higher 25% rate.)
Also, be aware that different rules apply to withdrawals from Roth IRAs and qualified plans, such as 401(k) plans.
Exceptions to the Penalty
So what are the exceptions to the 10% early withdrawal penalty? Let’s take a look:
1. Withdrawals for medical expenses. If you have qualified medical expenses in excess of 10% of your adjusted gross income (AGI), early IRA withdrawals up to the amount of that excess are exempt from the 10% penalty. To take advantage of this exception, you don’t need to trace the withdrawn amount to the medical expenses. However, those expenses must be paid in the same year during which you take the early withdrawal.
2. Substantially equal periodic payments (SEPPs). These are annual annuity-like withdrawals that must be taken for at least five years or until you reach age 59 1/2, whichever comes later. The rules for SEPPs are complicated, so you may want to get your tax advisor involved to avoid pitfalls.
3. Withdrawals after death. Amounts withdrawn from an IRA after the IRA owner’s death are always free of the 10% penalty. However, this exception isn’t available for funds rolled over into a surviving spouse’s IRA or if the surviving spouse elects to treat the inherited IRA as his or her own account. If the surviving spouse needs some of the inherited funds, they should be left in the inherited IRA (in other words, the one set up for the deceased spouse). Then, the surviving spouse can withdraw the needed funds from the inherited IRA without any 10% penalty.
4. Withdrawals after disability. This exception applies to amounts paid to an IRA owner who is found to be physically or mentally disabled to the extent that he or she cannot engage in his or her customary paid job or a comparable one. In addition, the disability must be expected to:
- Lead to death, or
- Be of long or indefinite duration. However, it doesn’t need to be expected to be permanent.
5. Withdrawals for first-time home purchases (up to a lifetime limit). This exception allows penalty-free IRA withdrawals to the extent the money is spent by the IRA owner within 120 days to pay for qualified acquisition costs for a principal residence. However, there’s a lifetime $10,000 limit on this exception. The principal residence can be acquired by:
- The IRA owner or the IRA owner’s spouse,
- The IRA owner’s child, grandchild or grandparent, or
- The spouse’s child, grandchild or grandparent.
The buyer of the principal residence (and the spouse if the buyer is married) must not have owned a present interest in a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as costs to acquire, construct or reconstruct a principal residence — including closing costs.
6. Withdrawals for qualified higher education expenses. Early IRA withdrawals are penalty-free to the extent of qualified higher education expenses paid during the same year. The qualified expenses must be for the education of:
- The IRA owner or the IRA owner’s spouse, or
- A child, stepchild or adopted child of the IRA owner or the IRA owner’s spouse.
7. Withdrawals for health insurance during unemployment. This exception is available to an IRA owner who has received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the preceding year. If this condition is satisfied, the IRA owner’s early withdrawals during the year in question are penalty-free up to the amount paid during that year for health insurance premiums to cover the IRA owner and his or her spouse and dependents. However, early withdrawals after the IRA owner has regained employment for at least 60 days don’t qualify for this exception.
8. Withdrawals by military reservists called to active duty. This exception applies to certain early IRA withdrawals taken by military reserve members who are called to active duty for at least 180 days or for an indefinite period.
9. Withdrawals for IRS levies. This exception applies to early IRA withdrawals taken to pay IRS levies against the account. However, this exception is not available when the IRS levies against the IRA owner (as opposed to the IRA itself), and the owner then withdraws IRA funds to pay the levy.
Before and After a Withdrawal
With some exceptions, IRA owners who make IRA withdrawals before age 59 1/2 must file a form with their tax returns. Specifically, they must file Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.”
If you think you qualify for an exception to the 10% penalty on early traditional IRA withdrawals, consider involving your tax pro before making a big early withdrawal. You want to be sure that you do indeed qualify. Better safe than sorry!