Exemptions to the Tax Penalty on Early Distributions from Retirement Accounts

The majority of distributions from retirement accounts are subject to state and federal income taxes. In addition, if you take a distribution before reaching age 59½, a 10% early withdrawal penalty will apply unless you qualify for an exemption. These distributions are considered premature or early. To encourage people to use their retirement savings for retirement, the IRS added the penalty to discourage early withdrawals.

However, understanding that certain situations warrant the necessity of withdrawing funds from your retirement account, lawmakers waived the penalty for several circumstances. Exceptions to the tax penalty on early distributions from retirement account include: rollovers, death, permanent disability, higher education expenses, equal periodic payments (SOSEPP), qualified first-time homebuyer’s expenses, unreimbursed medical expenses, and health insurance premiums.

Rollovers. If you rollover your funds from one retirement account into another eligible retirement account within sixty (60) days, the early withdrawal penalty does not apply. You will not owe state and federal income taxes on the distribution either.

Death. Distributions paid to beneficiaries, which are inherited after death, are exempted from the 10% penalty, even if the beneficiary is under the age of 59½. However, the penalty does apply, if the spouse inherits the retirement account and chooses to treat it as their own retirement account, rather than claiming the funds as a beneficiary.

Permanent Disability. Permanent disabled individuals, who take distributions from their retirement accounts, are exempt from the early withdrawal penalty. The IRS defines a disabled individual as someone who is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”

Unreimbursed Medical Expenses. If unreimbursed medical expenses - not covered by insurance - exceed 7.5% of your adjusted gross income (AGI), the amount you withdraw above the 7.5% of your AGI (up to the amount of the unreimbursed medical payments) to pay your medical expenses will be exempt from the 10% withdrawal penalty.

Example. John’s adjusted gross income was $50,000. He had a high deductible health insurance plan, and his unreimbursed medical expenses for the year totaled $5,000.

Because John’s unreimbursed medical expenses equaled more than 7.5% of his adjusted gross income, John could withdraw $1,250 ($50,000 AGI x 7.5% = $3,750) ($5,000 unreimbursed medical expenses - 7.5% of AGI or $3,750 = $1,250) from his retirement accounts, which would not be subject to the 10% withdrawal penalty.

Equal Periodic Payments. Your distributions from your retirement accounts are not subject to the 10% early withdrawal penalty, if you take a series of substantially equal periodic payments (or SOSEPP). To qualify, you must take the distributions for the greater of either five (5) years or until you reach age 59½. The IRS only allows three methods to determine the equal payments: required minimum distribution, fixed amortization, and fixed annuitization. If you are considering using this method, it is important to speak with a tax professional. If the plan is not exercised correctly, you will owe the 10% penalty on all the distributions taken, not just on the year you did not take the correct amount.

Higher Education Expenses (IRA only). Withdrawals from your retirement accounts to pay for higher education expenses for you, your spouse, children, or grandchildren are exempt from the 10% early withdrawal penalty, if the qualifying higher education expenses were incurred during the tax year the distribution was made. Qualifying higher education expenses include: tuition, room and board (if attending at least half-time), fees, books, supplies, and equipment required for classes.

Qualified First-Time Homebuyers Expenses (IRA only). If you are a first-time homebuyer, which the IRS defines as someone who has not owned a home in the last two (2) years, you may take a distribution of up to $10,000 from your IRA to pay closing costs. If you are married, your spouse also must meet the definition of a first-time homebuyer to qualify for the exemption to the 10% early withdrawal penalty. Also, the $10,000 limit is a lifetime cap. You may use the exemption to pay the closing costs for your children, parents, grandparents, or grandchildren, if they qualify as first-time homebuyers.

Health Insurance Premiums (IRA only). Distributions you take to pay for health insurance premiums are exempt from the 10% early withdrawal penalty, if you are (1) unemployed; (2) take the distribution at least sixty (60) days before starting a new job; (3) received unemployment for at least twelve (12) consecutive weeks; and (4) take the distribution the year or year after you received unemployment compensation. To qualify for the exemption to the 10% early withdrawal penalty, you must meet all four (4) of the requirements listed above.

The Bottom Line

If you are considering withdrawing funds from your retirement income, make sure you understand the tax consequences. If you need to withdraw funds from your retirement account early, you may qualify for an exemption to the 10% early withdrawal penalty. Some exemptions apply to qualified plans like 401(k)s, but not to IRAs, and vice versa. To qualify for an exception to the early withdrawal penalty, you will need to meet specific circumstances or spend the money on certain items. Even if you qualify for an exception to the 10% early withdrawal penalty, state and federal income taxes will apply unless you are making withdrawals from a ROTH IRA.

Sometimes, the tax consequences can be significant, and you may have better options. Contact the tax professionals at Gudorf Tax Group to review the amount of tax you will owe and develop tax planning strategies, if you are planning to take a distribution from your retirement account.