What Are the Exceptions to the 10% Early Withdrawal Penalty?
Individual retirement accounts (IRAs) are tax-advantaged savings vehicles designed to supplement your retirement income. If you withdraw the funds before age 59 1/2, however, income taxes and an early withdrawal penalty of 10% will apply.
Dean and Bud explain some of the most frequently used exemptions to this penalty imposed by the IRS for early withdrawals of more than 10% of funds from retirement accounts.
Death of the Account Owner
The IRS applies an early withdrawal penalty in order to discourage early withdrawals; otherwise you would incur income taxes as well as lose out on potential earnings over time. However, they recognize that life often throws us unexpected financial challenges, so there may be exceptions from their 10% early withdrawal penalty in certain instances.
As soon as someone dies, if they established a Payable on Death or Transferable on Death bank account, the funds will be released directly to that individual immediately upon learning of their death and receiving an official copy of their death certificate. With other accounts however, additional documentation from either their estate or executor may be required before funds can be distributed.
Distributions made after death may be used for state Medicaid reimbursement claims, funeral costs and estate taxes; or living expenses like rent or utilities. They are considered ordinary income subject to taxes as regular income with an additional 10% penalty imposed if the deceased account owner was under age 59 1/2.
Disability
One of the more frequent exceptions to the 10% early withdrawal penalty is if you have a disability, either physical or mental. Your disability must prevent you from engaging in substantial gainful activity for any considerable length of time or indefinitely.
The American Disabilities Act (ADA) defines disabilities as physical or mental impairments which substantially restrict one or more major life activities; this applies even if such impairment does not restrict current activity levels.
Under certain conditions, withdrawals from an IRA without penalty may be possible if needed to cover unreimbursed medical expenses exceeding 7.5% of income or to purchase, build, or rebuild your first home. There is also an exception available when withdrawing funds to satisfy IRS debts; TaxAct’s 401(k) calculator makes this easier by enabling users to check whether such exemption applies when entering their 1099-R distribution information.
Excess Contributions
While an IRA or tax-deferred account can provide tax advantages when saving for retirement, circumstances may necessitate early withdrawal of your money before reaching age 59 1/2. When that occurs, it’s crucial that you are aware of any exceptions available so as not to incur costly penalties.
If you contribute more than permitted, the IRS allows you to withdraw them without penalty until the tax filing deadline (including extensions) of the year after making them. However, any income generated as a result will still require income tax payments.
The 10% penalty does not apply to IRA withdrawals that are used for qualified medical expenses for either you, your spouse, children or grandchildren; provided they can itemize these expenses and withdrawals are made in substantially equal payments over life expectancy; otherwise it would apply.
Beneficiaries
If you leave behind tax-deferred retirement accounts such as an IRA or 401(k), your designated beneficiaries can access distributions without being subject to the 10% penalty tax; however, these distributions will still be considered gross income and subject to normal income taxes.
The IRS allows an exception to its 10% penalty when taking Substantially Equal Payments from your account over your life expectancy or that of both yourself and beneficiary, known as Substantial Equal Payment Plans or SEPPs. This provision is commonly known as 72(t), though SEPPs can be complex so before considering this approach it would be prudent to consult your CPA or adviser first.
The IRS permits withdrawals from an IRA or retirement plan account in order to pay for adoption costs or giving birth, provided you make this withdrawal within one year after either event. This provision serves as an exemption from early withdrawal penalties; moreover, SECURE 2.0 rules provide greater flexibility for this type of withdrawal.
Comments are closed here.