How Can I Avoid Paying Taxes on an Early IRA Withdrawal?

Tax rules surrounding individual retirement accounts are designed to encourage saving for retirement years, yet life may present unexpected financial needs that require you to withdraw early from an IRA without incurring the 10% early withdrawal penalty penalty. Understanding all applicable exceptions may help you address those needs without jeopardizing your long-term savings goals.

Medical expenses can be paid for using your IRA penalty-free, as can education costs for yourself, your spouse or children enrolled at eligible educational institutions and room and board fees at qualified facilities.

Disability

Savers in individual retirement accounts and workplace plans such as 401(k) typically incur a 10% early withdrawal penalty when withdrawing funds before age 59 1/2, but there are exceptions provided by the IRS for certain situations. For instance, disabled IRA owners can withdraw funds without incurring the usual 10% penalty; to report these distributions the financial organization should enter code “3,” Disability, in Box 7 of Form 1099-R for reporting purposes; many prefer instead entering code “1, Early Distribution with no Known Exception,” shifting responsibility of reporting such distributions back onto the IRA owner themselves for claim on Form 5329 when reporting this type of distribution occurs.

To qualify for the disability exception in an IRA, an owner must present evidence from a physician that confirms they are totally and permanently disabled. While this definition differs slightly from that used by long-term disability (LTD) providers who usually classify someone as totally disabled when his condition prevents him from engaging in any occupation, an IRA owner who receives this diagnosis can still take penalty-free distributions for medical expenses and paying premiums on privately purchased health insurance plans.

Unemployment

Typically, if you withdraw money from an IRA before turning 59 1/2, income taxes and a 10% penalty will apply; however, under certain conditions you can avoid incurring this additional tax liability.

Medical expenses are an exception to the penalty rule; you can withdraw tax-free funds from your IRA in order to cover unreimbursed medical costs that exceed 7.5% of adjusted gross income in the year that you took out a distribution, without needing to itemize deductions in order to qualify.

Unemployed individuals may also avoid penalties by using their IRA funds to cover health insurance premiums for themselves, their spouse and any dependents. According to Pederson, “You may be eligible to avoid penalties by collecting unemployment compensation for 12 weeks before withdrawing enough from your IRA to cover premiums,”

Avoiding penalties requires taking periodic distributions over your lifetime based on either your expected life expectancy or joint life expectancies with beneficiaries. Consult with a financial professional for this strategy which requires advanced planning and careful calculation.

Education

Financial emergencies often necessitate tapping into retirement savings early. Luckily, there are ways around the penalties associated with early withdrawal from an IRA account.

As an example, if you are the beneficiary of an IRA and withdraw money to cover qualified educational expenses – such as tuition, fees, books and equipment for an accredited institution as well as room and board expenses for those living on campus – then this withdrawal will not incur a penalty.

Medical expenses that exceed 7.5% of your adjusted gross income are exempt from penalties. Furthermore, you can withdraw penalty-free money to pay unemployment insurance premiums after 12 weeks without employment.

First-time Homebuyer

When buying their first home, the IRS provides an easy and penalty-free way for individuals to access funds from an IRA to cover any related costs such as down payments and settlement costs incurred when buying, building or renovating it – including down payments and settlement or closing costs. You have up to $10,000 available (lifetime limit).

Unreimbursed qualified medical expenses that exceed 7.5% of your adjusted gross income during the year in which the distribution is made can also be grounds for penalty-free withdrawal from an IRA. Note, though, these must occur during that same year in which distribution occurs.

IRA penalties are relatively rare and you can avoid them by understanding when and how they apply. Withdrawals from Roth IRA accounts do not incur penalties when used to pay for higher education, funeral expenses or disability expenses; however, you will owe income tax on earnings withdrawn before age 59 1/2 from traditional or SIMPLE-IRA accounts.


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