Assuming no exception applies, early withdrawal penalties from retirement accounts prior to age 59 1/2 will incur a 10% tax penalty tax. Fortunately, however, the tax code provides 16 exceptions that allow early distributions from retirement accounts without incurring this early withdrawal tax penalty tax.
While these exceptions could save money, be wary: any income taxes paid will reduce the potential long-term growth potential of your investments.
1. Withdrawals for Medical Expenses
Typically, withdrawing money from an IRA before reaching age 59 1/2 will incur a 10% penalty from the IRS; however, there may be exceptions to this rule.
Distributions made to cover medical expenses exceeding 7.5% of your adjusted gross income are exempt from early withdrawal penalties; however, they must be used during the same year as your distribution was taken and regardless of whether or not itemizing deductions is taken into consideration when doing so.
As another way to sidestep early withdrawal penalties, demonstrating “total and permanent disability” may also help. Though the IRS’ definition may seem strict, private letter rulings have shown otherwise; qualifying is possible by showing evidence of mental or physical incapacity that prevents you from engaging in any significant gainful activities.
2. Withdrawals for Education Expenses
IRAs and certain other tax-favored accounts do not impose the 10% penalty when withdrawing funds to cover qualified education expenses, including tuition, fees, books and supplies for at least half-time students as well as room and board costs. It’s essential that detailed records such as scholarship receipts be kept to substantiate these withdrawals.
Roth IRA contributions can be withdrawn without penalty at any time to pay for qualified education expenses, either for themselves, their spouses, or children enrolled in higher-education. It provides an ideal method of funding higher-education expenses.
However, we recommend Coverdell ESAs and 529 college savings plans as first choices when funding education costs. In such instances, these last-ditch options may prove invaluable should early withdrawal from retirement accounts become necessary.
3. Withdrawals for First-Time Homebuyer Expenses
Assuming you’re a first-time homebuyer, withdrawing funds from either your traditional or Roth IRA without incurring the 10% penalty may be possible; however, this exception requires specific circumstances so it is wise to consult your tax advisor prior to withdrawing money from either.
Deliberating how best to use your retirement account when purchasing a house is no small decision, and any premature withdrawal could cost a 10% penalty in addition to income taxes due on its distribution.
As a first-time homebuyer, there is an exception that allows you to withdraw up to $10,000 tax-free from your IRA without incurring penalties. Key requirements are that neither you nor your spouse has owned a residence within two years and use these funds within 120 days to cover qualified homebuying expenses.
4. Withdrawals for IRS Levy
Many people save for retirement with tax-deferred accounts like IRAs and employer plans like 401(k). Unfortunately, life can change unexpectedly and you need the money sooner than planned; fortunately there are exceptions to the 10% early withdrawal penalty in such circumstances.
One such withdrawals made to satisfy an IRS levy are exempt. When closing cases as hardship under IRM 5.16.1.2.9, make sure all open levies are released prior to closing your case on ICS as it could prevent receiving property that does not belong to you and incurring unnecessary bank charges. If you believe an incorrectly levied payment was collected from someone, follow IRM 5.11.4.9 procedures in order to reimburse their taxpayer – please see citations below for further information.
5. Withdrawals for Disability
Life throws us many surprises that require immediate access to funds in retirement accounts, so the tax code allows for 16 exceptions from its 10% early withdrawal penalty.
One exception allows individuals who suffer from permanent and total disabilities to make penalty-free withdrawals from their IRAs. To qualify, an individual must have an ongoing physical or mental condition which prevents them from engaging in any substantial gainful activities for the rest of their lives.
However, if the distribution is used to pay non-Qualified Disability Expenses such as housing expenses, its earnings portion could be subject to federal and state income taxes as well as a 10% penalty tax. Therefore it’s advisable to seek advice from a certified public accountant or enrolled agent prior to making early withdrawals so as to meet all the requirements.
