Retirement Account Early Withdrawal Penalties: Avoid Them
Do you have money in a retirement account you’re itching to get your hands on?
If you’re under age 59 1/2, you typically have to pay a 10 percent penalty tax on early withdrawals. And this penalty tax is in addition to the regular income tax you must pay whenever you withdraw your money from tax-deferred accounts such as traditional IRAs and 401(k)s.
The 10 percent penalty tax applies not only to tax-deferred retirement accounts but to Roth IRAs as well—but the penalty applies only to withdrawals of Roth account earnings, not contributions. Roth withdrawals are never subject to regular income tax if the account is held for over ﬁve years.
Here is the Good News: Several exceptions allow for penalty-free withdrawals before age 59 1/2. In fact, as a result of the SECURE 2.0 Act, there are now more ways to withdraw money from a retirement account penalty-free than ever before.
In this article, we cover the chief exceptions in place before the enactment of SECURE 2.0—and these exceptions remain in place after SECURE 2.0.
Penalty Exception 1: You Start Taking the Money
This is an exception to few people know about. It allows you to make penalty-free withdrawals simply because you want the money. You do so by taking substantially equal periodic payments (SEPPs) over time.
You need not use the money for any speciﬁc purpose or meet any other eligibility criteria.
You can, for example, use the money to supplement your income until you collect Social Security and/or other retirement beneﬁts. There are no age restrictions. An IRA owner could start taking SEPPs in his or her twenties.
But for withdrawals from qualiﬁed plans other than IRAs, this penalty exception applies only if an employee separates from service.
You must take your SEPPs at least annually for a minimum of ﬁve years or until you turn age 59 1/2, whichever is longer. You also have the option of taking SEPPs for your entire life and the life of your designated beneﬁciary.
If you stop the payments before the minimum holding period expires, you pay all of the 10 percent penalties the IRS waived on the withdrawals you took before you reached age 59 1/2, plus interest.
You calculate your SEPPs under the assumption that you will withdraw your entire retirement plan either throughout your entire life or throughout the lives of both you and your beneﬁciary. You must also use one of the three IRS-approved safe-harbor distribution methods:
- The required minimum distribution method,
- The fixed amortization method, or
- The fixed annuitization method.
Required Minimum Distribution Method
With the required minimum distribution method, you calculate your SEPPs using the IRS life expectancy tables. This is the same method retirees use to calculate their required minimum withdrawals after they reach age 73 (formerly 72).
Each year, you divide your account balance by your life expectancy factor as listed in the tables. Your SEPPs are redetermined annually based on the account balance and the number of years from the life expectancy tables.
This method will give you the smallest payments, especially in the early years. But since you recalculate your SEPPS each year based on your account balance, it ensures your account will not be exhausted by the SEPPs. It also allows for increased SEPPs when your retirement accounts do well.
The Other Two Methods
With the other two methods, you calculate a series of equal payments using an IRS-approved interest rate and a life expectancy table or annuity factor based on a formula used mostly by actuaries. You have some ﬂexibility because you get to choose the interest rate, which can be up to 120 percent of the highest federal mid-term rate.
Key Point: Unlike with the required minimum distribution method, once you compute your SEPPs with one of the two other methods, they stay the same over time, with one exception.
The One Exception: If you use the amortization or annuitization method, you are permitted to make a one-time switch to the required minimum distribution method at any time without incurring additional tax. Once this change is made, you must follow the required minimum distribution method in all subsequent years.
Note that if you have more than one IRA or another retirement account, you may take SEPPs from one, some, or all of them based on the amount in each account.
Penalty Exception 2: You Become Disabled
You can make penalty-free withdrawals if you become totally and permanently disabled before you reach age 59 1/2.
You are considered disabled if you can’t do any substantial gainful activity because of your physical or mental condition.
We’re not talking about a temporary disability. A doctor must determine that your condition is expected to
- Result in your death, or
- Have a long, continuous, and indefinite duration.
- Losing use of both arms or legs,
- Inoperable cancer, or
- Severe heart disease.
Penalty Exception 3: You Pay Medical Expenses
You can withdraw money from your retirement account to pay for unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income without incurring the penalty tax.
For example, if your AGI is $100,000 and your unreimbursed medical expenses are $10,000, you may distribute $2,500 from your retirement account penalty-free to pay them.
You must pay the medical expenses during the same calendar year you make the withdrawal.
Penalty Exception 4: You Leave Your Job
There is no penalty tax on money distributed from a qualiﬁed plan such as a 401(k), if you leave your job the year you turn 55 or later (age 50 if you’re a qualiﬁed public safety employee).
This exception does not apply to distributions from IRAs (including traditional, Roth, SEP, or SIMPLE IRAs).
Penalty Exception 5: You Die
If you die, the person inheriting the account will not be subject to the 10 percent penalty tax.10 If the beneﬁciary is your spouse, that individual can roll over the money into his or her own IRA or retirement plan tax-free.
Penalty Exception 6: The IRS Levies on Your IRA
If you owe money to the IRS and it actually levies on your IRA or qualiﬁed plan, you don’t have to pay a penalty on the amount the IRS took. The IRS doesn’t levy retirement accounts very often.
Penalty Exception 7: You Have Birth or Adoption Expenses
You can withdraw up to $5,000 penalty-free to pay for birth or adoption expenses. The $5,000 limit applies per child.
There are other exceptions to the 10 percent penalty, for:
- Certain distributions to qualified military reservists called to active duty,
- Certain natural disaster or pandemic-related distributions as specially designated by Congress or the IRS,
- Payments to a spouse or former spouse under a qualified domestic relations order.
Penalty-Free Withdrawals from IRAs Only
The following exceptions to the 10 percent penalty apply only to withdrawals from IRAs (traditional, Roth, SEP, and SIMPLE IRAs).
Youʼre a First-Time Homebuyer
You can withdraw up to $10,000 from your IRA penalty-free to purchase or construct a home for the ﬁrst time. You can use the money yourself, or it can be used by your children, grandchildren, or ancestors.
A person is a ﬁrst-time homebuyer if he or she did not own a principal residence during the prior two years. The $10,000 ﬁgure is a lifetime limit, and it applies regardless of whose home is purchased.
For example, if you withdraw $10,000 from your IRA and give it to your child for a ﬁrst-time home purchase, your lifetime limit is used up.
Distributions must be used within 120 days of receipt. But the money doesn’t have to be distributed all at once or even in a single year—for example, you could distribute $5,000 one year and $5,000 another year.
Unfortunately, $10,000 is not much given the cost of housing today. Lawmakers established the limit in 1997 as a ﬁxed amount with no adjustments for inﬂation.
You Are Unemployed and Pay for Medical Insurance
If you are unemployed and receive unemployment insurance for at least 12 weeks, you can take penalty-free IRA withdrawals to pay for your health insurance premiums, including long-term care insurance.
Self-employed individuals who don’t receive unemployment insurance qualify if they would have received unemployment had they not been self-employed.
You Pay Higher Education Expenses
Penalty-free IRA withdrawals may also be taken to pay for qualiﬁed higher-education expenses for yourself, your spouse, or any child or grandchild. These expenses include books, tuition, supplies, room and board, and postsecondary education.
Here are ﬁve takeaways from this article:
- Withdrawals before age 59 1/2 from an IRA, a 401(k), or any other qualified retirement account ordinarily result in a 10 percent penalty tax in addition to regular income taxes. But there are numerous exceptions to the penalty.
- No penalty will ever be due on early withdrawals from your 401(k) or other qualified plan if you leave your job after age 55. But this exception does not apply to traditional, Roth, SEP, or SIMPLE IRAs.
- You may withdraw funds penalty-free from your IRA before age 59 1/2 if you take substantially equal periodic payments for at least five years or until you reach age 59 1/2. But for distributions from qualified plans other than IRAs, this exception applies only if an employee separates from service.
- You may withdraw any amount penalty-free if you become disabled before age 59 1/2.
- Penalty-free withdrawals are also possible to purchase or build a first home for yourself or your family; to pay for medical expenses or medical insurance, higher-education expenses, or adoption expenses; or to pay the IRS when it levies on your IRA.
We hope this article has shed some light on the importance of properly managing your business assets and maximizing your deductions.
The good news is that there are a few exclusions that permit penalty-free withdrawals before the age of 59 1/2, and with the passage of the SECURE 2.0 Act just recently, there are now even more alternatives than before. The main exceptions to the rule discussed in this article, along with a little-known technique that lets you get substantially equivalent monthly payments (SEPPs) throughout time with no age or qualification requirements.
At Morris + D’Angelo, we understand that everyone is unique and we are here to help you navigate the complexities of tax planning and asset management. If you have any questions, need clarity, or need assistance in maximizing your financial security, please contact us at Morris + D’Angelo. This is our Expertise!
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
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