What Are the Exceptions to the 10% Early Withdrawal Penalty?
As a rule, withdrawals made from retirement accounts before age 59 1/2 require a 10% penalty, though there may be exceptions to this rule.
These include your aftertax contributions; qualified medical expenses; the IRS levies any unpaid federal taxes due; and substantially equal periodic payments (SEPPs). There may also be some exceptions specific to IRAs and 401(k) plans.
1. Withdrawals for Medical Expenses
Depending on the nature of your medical expenses, early withdrawal from an IRA to pay them off could allow you to avoid incurring the 10% early distribution tax penalty. You must still report it as income on your tax return but won’t incur the added 10% tax charge.
Qualified medical expenses typically include annual checkups, prescription medications and certain surgeries; they do not, however, include elective procedures like plastic surgery that may not be medically necessary.
Distributions made from an IRA to cover eligible higher education expenses for you, your spouse or your children and grandchildren are exempt from the 10% early withdrawal penalty. Note, though, that such expenses must have been incurred within one year of making the withdrawal request.
2. Withdrawals for Disability
Even though IRAs are intended to provide income in retirement, there may be times when early withdrawal is necessary. Although IRS rules on this topic are complex, there may be exceptions which allow you to meet unanticipated financial needs without jeopardizing long-term savings plans.
The most prevalent exception is for withdrawals related to disability. You can withdraw funds penalty-free before reaching age 59 1/2 for what the IRS refers to as Qualified Disability Expenses, such as unreimbursed medical costs exceeding 7.5% of adjusted gross income or the costs associated with moving or opening a business.
To qualify, you must submit proof of your disability – such as medical documentation from a physician, or even government-backed disability determination such as Social Security or Medicare.
3. Withdrawals for Death
Many employer-sponsored plans and IRAs allow you to withdraw funds without incurring a penalty fee; however, you usually must still pay income tax since pretax dollars were used to fund the account.
There are only a handful of exceptions to the 10% early withdrawal penalty; however, they could prove useful should you need access to your retirement savings before age 59 1/2. Dean and Bud discussed several of these exceptions on America’s Wealth Management Show as well as during an Ed Slott workshop held recently in Baltimore.
The 10% early withdrawal penalty is assessed in addition to ordinary income taxes and is designed to encourage long-term savings through tax-advantaged retirement accounts. Before making any decisions on your own, always consult a financial or tax professional first.
4. Withdrawals for Excess Contributions
Tax-advantaged retirement accounts provide tax savings opportunities. Unfortunately, unexpected financial needs can arise that require early access to these savings accounts.
Early withdrawals may incur a 10% penalty from traditional, Roth and self-employed pension (SEP) IRAs; however, the IRS has granted some exemptions to this penalty.
One of the key exemptions is substantially equal periodic payments (SEPP). This allows you to access your IRA funds without incurring a 10% penalty by creating an annual distribution that’s substantially equal to your life expectancy. Another important provision is levy exemption, which permits withdrawals made to pay an IRS levy without penalty; however, you must report investment earnings as income on your tax returns.
5. Withdrawals for Rollovers
Rollover distributions from employer plans into other retirement accounts are considered income but do not incur an early withdrawal penalty; however, an additional 10% tax applies if you’re younger than age 59 1/2 at the time of rollover.
You are also exempt from penalties when withdrawing funds to purchase your first home, either using an IRA or employer plan.
When using an individual retirement account withdrawal to cover qualified medical expenses that exceed 10% of your adjusted gross income – such as copays and deductibles – there will not be a penalty assessed against you.
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