Exploring the Exceptions: Early IRA Withdrawals Without Penalty
We often joke that when you ask a CPA a tax question, their answer is always, “It depends.†Then last week, we received an email asking, “Is there a way to avoid the 10 percent early withdrawal penalty from an IRA?†Our reaction was, “It depends.â€
To begin, distributions taken from a traditional IRA before age 59 ? are generally referred to as premature distributions. To discourage investors from raiding their retirement funds, premature distributions are subject to a 10 percent federal penalty tax (and possibly a state penalty tax) in addition to federal and state income taxes that are due.
Our response for an investor at age 25 is quite different than it would be for a 52-year-old investor. We almost never recommend tapping your retirement funds unless there isn’t any other option. These accounts should be your last resort. Investors should use after-tax investments in brokerage accounts first.
However, if you are in your 50s, and looking to bridge the gap between now and when you turn 59 ?, you can withdraw penalty free, using an exception under Section 72(t) allows investors to take substantially equal periodic payments. These payments are required for at least five years or until you reach 59 ?, whichever is later. The harsh reality is this strategy is complicated and requires a professional’s attention.
Upon the death of an IRA account owner, assets are passed to the named beneficiaries. While ordinary income tax will be due on the distributions, they are not subject to an early withdrawal penalty should the beneficiary be younger than 59 ?. Most often the beneficiary is the person’s spouse, who has the most options on what to do with the account. Non-spousal beneficiaries must withdraw all funds from an inherited IRA within 10 years of the original owner’s death.
Assuming death is not the preferred option to avoid taxes and penalties, the IRS provides several exceptions that may allow investors penalty free access to their savings. Totally and permanently disabled retirement savers under age 59 ? are not subject to the penalty. You may be exempt if IRA funds are used to pay qualifying higher-education costs for you, your spouse, or the children or grandchildren of you or your spouse.
If you lose your job, you may be able to use IRA funds to cover health insurance premiums for you, your spouse, and dependents. Similarly, you may be able to cover unreimbursed medical expenses that exceed 7.5 percent of your annual adjusted gross income. The IRS also allows you to pull funds from a traditional IRA without penalty for a first-time home purchase up to $10,000. To qualify as a first-time buyer, you cannot have owned a home in the last two years.
Nevertheless, just because you can, doesn’t mean you should. You will not be able to recontribute the funds into the IRA after they have been withdrawn because you are limited to an annual maximum contribution of $6,500 or $7,500 for those 50 and older. With any withdrawal, you are giving up the tax-deferred growth benefit of those funds.
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