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Money February 2013

Dollar Sense

How Can I Avoid Early Withdrawal Penalties on My IRA or 401(k)?

By Teresa Ambord

If you have a Roth IRA, you are not required to take distributions after age 70 ½. However for traditional IRAs, you must take a required minimum distribution (RMD) every year, or face a harsh 50 percent penalty on the amounts you should have taken.

Generally, contributions you made to your traditional IRA or 401(k) gave you federal tax advantages at the time they were made. So it stands to reason that if you take that money out before a certain age – 59 ½ – there will be tax consequences, including a penalty. The good news is, you may be able to avoid the penalty if you fall under one of the exceptions listed below. But first, here is a reminder of the tax consequences.

Assuming the contributions you made were tax deductible, taking money out of your account before you reach age 59 ½ will mean you pay a 10 percent early withdrawal penalty, and the amount of the distribution itself will be subject to your federal tax rate. In other words, if you take an $8,000 early withdrawal at age 58, you can expect to pay an $800 tax penalty, as well as having that $8,000 added to your taxable income. Here is a list of exceptions that may help you bypass the penalty (though just to be clear, even if you escape the penalty these withdrawals are still subject to ordinary income tax). Note, some exceptions apply only to IRA or qualified retirement accounts, but not both.

Exceptions

  • Medical expenses. If you pay medical expenses of more than 10 percent of your adjusted gross income in 2013, you can take funds – penalty-free – from your retirement account to pay the excess (for 2012 this was 7.5 percent. If you or your spouse is 65 at the end of the year, the new 10 percent of AGI threshold will not take effect till 2017). This is true even if you do not itemize your deductions, but you must pay the expenses in the same year as you take the withdrawal.
  • IRS levies. You can use retirement funds to pay federal tax levies against you, and remain exempt from the penalty.
  • Military Reservist. If you are a member of the military reserves and you get called to active duty for at least 180 days, you are generally exempt from the penalty.
  • Separation from service. If you are at least 55 and leave your employer – by quitting, retiring, being fired or laid off – you are exempt from the 10 percent penalty on retirement account funds. If you are a qualified public safety employee you only need to be age 50. Note: this exemption applies to your 401(k) funds, not IRA. If you later roll your distribution into an IRA, you will not enjoy the same exception, so be careful only to use funds that you can be reasonably sure you will not need for a while.
  • Disability. If the account owner is physically or mentally disabled, early withdrawals are not penalized. However, the account owner must be disabled to the point that he or she cannot work in his or her usual job or activity or a similar job or activity. To qualify for this exemption, you must be able to furnish proof of the disability and show that the disability is expected to be long or indefinite or to lead to death.
  • Higher Education. IRA funds can be taken penalty-free, to pay qualified higher education expenses during the year – for you, your spouse, child, stepchild, or adopted child.
  • Certain Health Insurance Premiums. You may use IRA withdrawals to pay health insurance premiums for yourself, your spouse, or your dependent children without penalty if you have been receiving unemployment compensation for 12 consecutive weeks during the current or preceding year. However, note that if you regain employment within at least 60 days and take withdrawals after re-employment, those withdrawals will be subject to the penalty.
  • First Time Home Purchase. You can use IRA withdrawals to make a first time home purchase under these conditions. The home is the principal residence for you, your spouse, your child, grandchild, or grandparent, or your spouse’s child, grandchild, or grandparent, and the purchase can be made by any of these individuals. The buyer (and spouse if applicable) must not have owned a principal residence within the two-year period that ends with the date of purchase. The withdrawal is subject to a lifetime limit of $10,000 to be used for acquisition costs, and the funds must be paid within 120 days of taking the withdrawal.
  • Substantially Equal Periodic Payments (SEPPs). These are account withdrawals of equal amounts, made annually, similar to an annuity. These payments can avoid the penalty, but the rules are complex so it’s a good idea to seek advice from a tax pro before embarking on such a plan.
  • Court Ordered Payments Relating to Divorce. Withdrawals that are paid to your spouse or ex-spouse pursuant to a court order in a divorce proceeding are exempt from the penalty. This exception is not available for IRA withdrawals.

As you can see there are many exceptions to the 10 percent penalty that make it possible to use your own money for major life events. However, the withdrawals you take will generally still be considered taxable income in the year you take the funds. Also, the exceptions are generous but not without limits, so proceed with caution. Before you make a rash decision, talk to your financial advisor or ask for a consultation with a representative at your bank who handles retirement instruments.

 

SIDEBAR: What Kind? What Age?

IRA Withdrawals Between 59 ½ and 70

During these years you can withdraw funds from a Roth or a traditional IRA without penalty. However, keep in mind that money taken from a traditional IRA will be subject to ordinary income tax regardless of your age. Funds taken from a Roth IRA will not be subject to federal income tax, provided you opened the account and made the first contribution at least five years ago. Of course, you should leave the funds untapped as long as possible for the best tax-advantaged growth.

Withdrawals After 70 ½ for IRAs, Roth IRAs, and Other Plans

If you have a Roth IRA, you are not required to take distributions after age 70 ½. However for traditional IRAs, you must take a required minimum distribution (RMD) every year, or face a harsh 50 percent penalty on the amounts you should have taken. Talk to your financial advisor to be sure you are taking at least the minimum. The first distribution must be taken by April 1st of the year after you turn 70 ½.

Some qualified retirement plans may require participants to begin receiving payments even if they are not yet retired. In general, however, the IRS states that participants must begin receiving payments by April 1 of the first year after the later of the following years:

  • Calendar year in which the participant reaches age 70½, or
  • Calendar year in which the participant retires.

Inherited IRAs

If you have inherited an IRA you must begin taking distributions no later than December 31st of the year following the death of the account owner. The decisions you make about distributions can have important consequences, so talk to a trusted advisor before taking action.

 

Teresa Ambord is a former accountant and Enrolled Agent with the IRS. Now she writes full time from her home, mostly for business, and about family when the inspiration strikes.

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