The latest version of The Kiplinger Tax Letter has a good overview of some key considerations that can occur when an IRA owner takes a distribution out of his or her IRA prior to age 59 1/2. In addition to owing income tax on the IRA distribution (assuming a Roth IRA is not involved), a 10% penalty can apply. There are some large exceptions to this penalty, but the IRS has revealed that up to 40% of individuals that take distributions prior to age 59 1/2 do things incorrectly – and thus, the 10% penalty applies. Below is a summary of several key exceptions to the 10% penalty rule – be careful you qualify!
Early withdrawals from IRAs to help “first-time” home buyers are penalty-free. IRA owners can take out up to $10,000 to help buy or build their primary home or one for a spouse, child, grandkid, parent or grandparent. The funds must be spent within 120 days. You can be a first-time homeowner even if you owned a home before, as long as you and your spouse didn’t own a home in the previous two years.
Early distributions to pay for “higher education” can also qualify for the penalty exemption (e.g., college tuition, books, computers, supplies, and room and board for students enrolled at least half-time). Unlike for home buyers, there’s no dollar cap. To qualify for the exception, payouts must cover education costs for the IRA owner, spouse, child or grandkid that are paid in the year of the withdrawal.
WARNING: Early distributions from 401(k)s for education or first homes don’t get relief.
Taking “substantially equal payments” from an IRA or 401(k) is a key exception. Distributions must continue for the longer of five years or until the recipient hits 59 1/2. Withdrawals must be based on the owner’s life expectancy or the joint life expectancy of the owner and named beneficiary. If the payouts vary too much from year to year, all previous distributions taken from the account will be hit with the 10% penalty. Being VERY PRECISE with this exception, both initially and on-going, is critical.
IRAs and 401(k)s can be utilized to pay big medical expenses without penalty. The funds must be used for medical costs of the taxpayer, spouse or dependent. The payout must cover expenses paid in the year of the withdrawal. And only medicals that exceed 10% of adjusted gross income (7.5% for 2018) qualify for the exception.
The unemployed can use IRA funds to buy health insurance in some cases. Payees must be on unemployment for 12 weeks. Self-employed individuals also qualify.
Three other exceptions to the penalty don’t allow much planning:
Death or permanent disability of the account owner or IRS levy on retirement funds.
IRS has a helpful chart listing all withdrawals that escape the 10% penalty. It describes the exceptions, notes those that apply to 401(k)s and those that apply to IRAs, and lists the section of the income tax code where the exception appears – see here: https://www.irs.gov/pub/irs-tege/early_distributions.pdf