It's highly likely that you own a traditional IRA. You are probably aware of or have heard that the IRS charges 10% early withdrawal penalty. You pay that for withdrawing money before reaching age 59 1/2. That's true for your traditional IRA, your employer retirement plan, and nonqualified withdrawals from a Roth IRA.
Did you know there are many exceptions to the pre-59 1/2 withdrawal rule?
Maybe you've heard about one or two. There are many more. In today's post, I'll introduce you to 16 ways you can avoid the 10% early withdrawal penalty.
Some exceptions apply to IRAs. Others apply to employer retirement accounts. Some exceptions apply to both.
I've said it before, and it bears repeating. The IRS rules for retirement accounts are numerous and confusing. Penalties for not getting them right can be severe. My goal today is to help you understand the rules for early withdrawals.
NOTE: This information is provided for general information only, and is not intended as personalized investment advice. This presentation is not intended to be any form of financial planning, investment, tax or legal advice. There is no substitute for individualized investment advice, and no conclusions should be drawn from this information. All readers should contact their professional investment, legal and tax advisors before entering into any investment or investment agreement.
Avoid the 10% Early Withdrawal Penalty
1. 72(t) payments
Also known as the substantially equal periodic payments (SEPP), the 72(t) withdrawal options are probably the best known. There are a couple of common ways to take advantage of this option.
If you own an annuity in your IRA, you can annuitize the contract over your lifetime. Doing so avoids the early withdrawal penalty. However, annuitization does not allow for additional withdrawals of cash (assuming you annuitize the entire account value). You can't stop the payments once initiated.
The other option is the SEPP. Here, payments are based on life expectancy and account balance. Like RMDs, the account balance used is the prior year-end balance on December 31. You can use the single life expectancy table or joint life and last survivor table. The payment period must be a minimum of 5-years or age 59 1/2, whichever is greater.
For example, if you started your SEPPs at age 52, your payment period would be seven years (ending six months after your 59th birthday). If you start at age 57, your minimum period is six months after you reach age 62 (five years).
You can find a full discussion of the rules on IRS FAQ page for substantially equal payments.
If the IRA owner dies, the beneficiaries can take distributions without penalty at any time. Regardless of their age at the time of withdrawals, beneficiaries are exempt from the 10% early withdrawal penalty.
Disability may seem an obvious choice for not paying early withdrawal penalties. However, like Social Security, the definition of disability is VERY restrictive.
Many private disability policies have a liberal interpretation of disability. They might say unable to perform in your or a similar profession. They may even have an what's called an “own occupation” definition. That means if you're a surgeon, and can no longer perform surgery, you qualify as disabled. Even if you can practice another type of medicine, own occupation means you still qualify.
The IRS definition for early withdrawals is your being unable to engage in ANY substantially gainful activity. They go on to say the disability must either be expected to end in death or be of an indefinite period. Like Social Security, qualifying for the disability exception is very difficult.
4. First-time homebuyer
First-time homebuyers can withdraw up to $10,000 for the purchase of a house. The house doesn't have to be in the IRA owner's name alone. If married, and the house is in joint title with your spouse, the exception still applies. The benefit extends to your spouse, children, and grandchildren as well. In other words, if you want to give your kids a head start on their first house purchase, you can take up to $10,000 from your IRA and not pay the 10% early withdrawal penalty (assuming you're under age 59 1/2).
The IRS criteria to qualify as a first-time homebuyer is not having any interest in a principal residence for the prior two years.
5. Medical expenses
If you incur medical costs over what insurance pays, you can deduct those expenses up to the amount allowed when filing your income tax return. Before the Tax Cuts and Jobs Act, the deductible amount was anything over 10% of adjusted gross income (AGI). The Tax Act lowered that threshold to 7.5% for tax years 2017 and 2018. In 2019 and beyond, the limit goes back to 10%.
Remember that the Tax Act also raised the standard deduction to 12,000 for individuals and 24,000 for married couples filing joint returns. The good news is you don't have to itemize to get the medical expense exception. Be sure to calculate this number even if you don't itemize.
6. Active reservist
If a reservist gets called into active duty for 180 days or more, they are exempt from the 10% penalty for any money taken out of their IRAs.
7. IRS levy
If you owe the IRS money and withdraw from your retirement account to pay the bill, you will pay the 10% early withdrawal penalty. If, however, you owe the IRS money and there is no other place to get it other than the IRA, you want to let the IRS levy (take) that retirement account. It's one of the few exceptions when it may make sense to let the IRS take your money. You'll still owe income tax on the withdrawals, but not the 10% penalty.
Another popular exception many people use is higher-education. Distributions to pay for post-secondary education expenses like tuition, books, supplies and required equipment may qualify for the 10% penalty exception. Room and board qualify too as long as the student attends an eligible institution on at least a half-time basis.
Like with the first-time homebuyer exceptions, the money can go to the IRA owner, a spouse, children, stepchildren, and grandchildren of the IRA owner or spouse.
9. Health insurance for the unemployed
If you had an IRA and received at least twelve weeks of unemployment compensation either in the current or previous year, you qualify for the 10% penalty exception to pay for health insurance premiums. Premiums can be used for the IRA owner, spouse, and dependents.
10. Age 55 exception
If you leave your employer in the year in which you turn age 55 or later, you can take a penalty-free distribution from your employer-sponsored retirement plan. The rule applies only to the plan where you are currently employed and leaving. If you have 401(k)s at former employers that you haven't moved, you cannot withdraw money from them without paying the 10% penalty.
11. Qualified Domestic Relations Order (QDRO)
If you're involved in a divorce and one of you receives a portion of the other's employer plan under a QDRO, you can take penalty-free distributions from the plan at any time. However, any distributions from the QDRO plan must follow the distribution rules set up by the employer. If there are restrictions on withdrawals, those need to be followed. In other words, recipients of the QDRO can't force the company to make a distribution contrary to the plan rules.
12. Governmental 457(b) plans
The most straightforward rule of all. The 10% early withdrawal penalty does not apply to these plans. One of the few times it's that simple.
13. Age 50 public safety workers
Similar to the age 55 exception, the age 50 exception applies to certain public safety workers. The rule applies to employer-sponsored plans and applies to workers who separate from service at age 50 or later and take withdrawals from their plan. Eligible workers include police officers, firefighters, EMS workers, and certain federal law enforcement officers. It includes specific border patrol agents, customs officials, and air traffic controllers. U.S. Supreme Court police officers and members of the Capitol Police, special diplomatic agents of the State Department, and specific materials couriers.
In 2015, two pieces of legislation expanded the list of eligible employees substantially. It applies only to the employer-sponsored plan the eligible employee separates from after reaching age 50.
14. ESOP dividends
An employer stock ownership plan (ESOP) issues non-publically traded stock of their companies to employees. Dividends from stock held of your retirement plan are exempt from the ten tax if taken before age 59 12.
15. Qualified hurricane distributions
The deadline for using this exception was December 31, 2018. I include it here in case you live in an area where hurricanes are frequent. The hurricanes listed below came in rapid succession and caused hundreds of billions of dollars in damages. Hopefully, events like this won't happen again. If they do, I want you to be aware of this potential help.
If you had an economic loss as the result of hurricane Harvey, Maria, or Irma, and your primary residence lies within one of the areas declared a federal disaster area, you could have taken a distribution up to $100,000 penalty free. The taxable distribution could be spread over three years to help spread the bill out to ease the burden.
16. Qualified Wildfire distributions
Another set of natural disasters occurred in California with the spread of wildfires throughout the state. Similar to the hurricane relief, those who lived in a federally designated disaster area could take up to $100,000 from their retirement accounts penalty free. You could spread this tax out over three years as well. Like the hurricane relief, you must have taken your distribution by December 31, 2018. If you live in an area prone to wildfires, be aware of this benefit if, God forbid, you are affected by a wildfire.
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Source: Jeffrey Levine CPA/PFS, CFP®, CWS®, MSA, Fully Vested Advice, Inc.
Of course, it's best to avoid taking distributions from accounts set aside for retirement before age 59 1/2. The taxes are costly enough. Adding the 10% early withdrawal penalty to the bill makes it even more costly.
Having a proper savings and investing strategy to meet your long-term spending needs is the best way to avoid these penalties. Spending less than you make. Saving and investing regularly, and reducing or eliminating death will help you avoid the tapping into this money.
As a financial advisor, I also realize that things happen in life that throw off our best-laid plans. Things like the California wildfires and the rash of hurricanes are not something we can adequately plan for. In my practice, I help people prepare for and get through retirement in a way that maintains the lifestyle they desire. I also understand the planning process is dynamic. It isn't a one and done exercise.
If you plan and prepare for life's unexpected events by having a sizeable emergency fund, saving and investing for the long-term, planning your life based on the things important to you, the things you value, you will put yourself in the best possible position to live the kind of life and retirement you desire.
For those times when emergencies necessitate extreme measures (like tapping retirement accounts), you now have the information you need to understand the rules and exceptions to make the best decisions.
Now it's your turn. Have you had to tap into your retirement accounts early? Were you aware of these exceptions? Do you have a plan in place to minimize the chances of having to tap into these accounts? Let me know in the comments below.