At first glance, taking distributions from a retirement plan before age 59 1/2 usually triggers an additional 10% penalty tax; however, there are exceptions that allow savers to avoid this tax penalty.
There are exceptions to the penalty tax for withdrawals made for medical expenses, buying a first home or satisfying an IRS tax levy. Learn more about these potential exceptions:
1. Withdrawals for medical expenses
Withdrawals from IRAs may be made without incurring penalties in order to cover unreimbursed medical expenses, such as annual checkups, prescriptions and treatments like surgery. This does not include elective procedures (like cosmetic surgery).
One exception to the 10% early withdrawal penalty exists if you withdraw money to start making substantially equal periodic payments, also known as 72(t) payments, such as an annuity contract. Payments must be made at least annually until reaching age 59 1/2.
Avoiding the 10% early withdrawal penalty can be achieved if you withdraw funds to purchase a home, pay health insurance premiums while unemployed, satisfy an IRS levy and more. Please check with your tax professional first when taking any actions related to withdrawing funds early from an IRA account.
2. Withdrawals for first-time homebuyers
Finding your first home can be daunting, and finding enough money for the down payment may prove even harder. The IRS provides an exemption to its 10% early withdrawal penalty that allows IRA owners to withdraw up to $10,000 penalty-free from investment earnings in order to cover a first-time home purchase, provided certain conditions are met within two years of receiving distribution and within 120 days of closing on it.
Account owners could face income taxes on money withdrawn plus the 10% early withdrawal penalty; however, there are exceptions that help first-time homebuyers access funds easily.
3. Withdrawals for education expenses
SEP IRAs, designed for sole proprietors and small businesses with few employees, feature different rules than 401(k) plans and allow funds to be withdrawn without penalty in certain situations – including financial hardship, home purchase costs and qualified education costs.
Tuition, fees, books and room and board costs qualify as qualifying higher education expenses. Just make sure that the amounts withheld don’t go beyond your lifetime education expenses as an individual or couple. Also keep thorough records such as account statements that list tuition and fees separately as well as receipts for equipment/accessories purchases made using funds as well as syllabi/syllabus of classes taken and cancelled checks from payment plans.
Other exceptions to the 10% early withdrawal penalty include substantially equal periodic payments (SEPPs), IRS tax levies, medical expenses and national guard and reservist distributions. To claim these, complete Form 5329 and follow its instructions.
4. Withdrawals for qualified transportation expenses
If you use funds from your IRA to pay for qualified transportation expenses like vanpooling, transit passes or parking spots that qualify as qualified expenses, including vanpooling, transit passes or qualified parking spots that qualify, the 10% penalty may be waived. This exception also covers expenses funded directly through employer reimbursement or salary reduction contributions from employees.
IRS rules offer 16 exceptions to the 10% early withdrawal penalty, each with specific conditions that must be fulfilled to take advantage of one. In order to do so, you must establish a schedule of substantially equal periodic payments (SEPPs) until age 59 1/2 or five years have passed (whichever comes later), or use this exception for disability insurance premium payments; but note that any amounts paid must not exceed your actual expenses.
5. Withdrawals for qualified long-term care expenses
Individuals often find it daunting to consider end-of-life care costs as an expense that must be borne. There are various strategies available to fund these costs.
Redrawals made to pay long-term care premiums are exempt from the 10% early withdrawal penalty, provided they can be directly traced to a medical diagnosis. This exception applies both to individual retirement accounts (IRAs) as well as employer sponsored plans such as 401(k).
As most traditional long-term care insurance purchasers tend to purchase policies after age 55 or 60, this strategy may only benefit a portion of those new policy owners. A better approach could be withdrawing funds from vehicles that allow deductibility of expenses like HSAs – providing your heirs with tax breaks while keeping you protected against financial reversals.