How Can I Avoid Paying Taxes on an Early IRA Withdrawal?
Savers who withdraw funds from their retirement accounts prior to reaching age 59 1/2 will usually face a 10% tax penalty fee; however, certain exceptions exist.
You may avoid paying the penalty when withdrawing funds for qualified medical expenses or home purchases made before age 59 1/2, total and permanent disability and unemployment compensation benefits, among other circumstances.
1. Take a Series of Substantially Equal Periodic Payments (SEPPs)
Savers who withdraw funds from retirement accounts before age 59 1/2 typically incur a 10% tax penalty, but in certain instances this penalty can be avoided.
This exception, known as the 72(t) payment strategy, requires savers to follow an IRS-approved distribution method which involves taking at least one withdrawal annually based on their life expectancy and maintaining this plan for at least five years or until age 59 1/2, whichever comes first.
SEPPs can be used to pay for medical expenses, first-time home purchases and certain education costs like tuition fees, books, supplies, equipment required for enrollment/attendance as well as room and board. But Slott warns that using SEPPs improperly could prove costly.
2. Delay the Distributions
Early withdrawals from an individual retirement account (IRA) generally incur a 10% early distribution penalty; however, there are ways to circumvent it.
By making substantially equal periodic payments (SEPPs), which resemble an annuity, you may be able to avoid penalties. But the process of identifying and withdrawing enough for all the years required can be complex and may need professional advice in order to be successful.
Furthermore, SEPPs must pay income tax. You can avoid a 10% penalty by using them for qualifying medical expenses or first-time home purchases; should you decide to use SEPPs for health insurance purchases instead, an advisor can help determine which option best meets your financial goals from a tax perspective.
3. Use a Roth Conversion
IRAs were meant for retirement savings, but unexpected expenses may require withdrawals from these accounts to cover unexpected costs. While withdrawing funds may incur penalties, there may be exceptions that allow you to do this without incurring unnecessary charges.
One way to sidestep penalties is to convert your traditional IRA or workplace plan such as a 401(k) into a Roth account. Although this will result in a tax bill in the year of conversion, any future withdrawals tax-free will make this conversion worthwhile if your retirement tax bracket increases significantly, or taxes rise substantially in the near future. Before making such a conversion decision it is wise to carefully evaluate all associated risks before taking action.
4. Wait for the Five-Year Rule
Traditional and Roth IRAs both require their holders to abide by certain withdrawal guidelines when withdrawing money, otherwise additional taxes and penalties could significantly diminish your retirement savings.
First and foremost is a five-year clock which must run before withdrawing converted principal or investment earnings from your conversion account. This clock starts counting from when it was converted until age 59 1/2 is reached.
However, most individuals won’t need to consider this rule due to so-called ordering rules. Under these guidelines, withdrawals are typically made first from after-tax contributions made prior to conversion and earnings earnings – therefore allowing you to bypass the five-year rule and any associated penalties.
5. Consult a Tax Professional
Withdrawals from retirement accounts can be complex for those under 59 1/2. If you take an early withdrawal that does not qualify for an exception, regular income taxes and an additional 10% penalty tax will apply to any amounts withdrawn before age 59 1/2.
There may be situations in which you can avoid paying this penalty, including purchasing your or a spouse’s first home, covering medical expenses that exceed 7.5% of adjusted gross income or covering funeral costs. Before taking such actions or distributions, however, always consult a tax professional first in order to ensure eligibility.
Tax professionals can assist in finding ways to lower your tax bill, such as strategically timing distributions and making use of applicable exemptions. They may also assist in planning for expenses that might arise during retirement.