I was working with a client recently that wanted to establish a provision in his estate plan to provide for their grandchildren’s education. A large part of their net worth was in a Traditional IRA. The client wanted to know if they left a portion of their IRA to the grandchildren, would the withdrawals be tax-free if the grandchild used them to pay for college expenses. The answer is no, but it reminded me of the confusion that surrounds the difference between penalty-free and tax-free withdrawals.If you’re younger than 59½, any distribution from a traditional IRA, Simplified Employee Pension (SEP) IRA, Savings Incentive Match Plan for Employees (SIMPLE) IRA and Roth IRA is considered a premature distribution and is subject to ordinary income tax and a 10% penalty. There are exceptions to the 10% penalty but generally, money withdrawn from a retirement account, regardless of the reason, is subject to income taxed as ordinary income. However, depending on the individual’s circumstances, they may not owe any tax on the distribution. The distribution could be sheltered by the individual’s deductions and personal exemptions resulting in no tax due. Unfortunately if the withdrawal is subject to penalty, a tax penalty cannot be offset by deductions or personal exemption, a fact that catches many unsuspecting taxpayers by surprise.In my client’s situation, the grandchild would be able to avoid the 10% early withdrawal penalty based on several exemptions in this situation.
Exemption 1 — Qualified higher education expenses
Penalty-free withdrawals are also available if you need to pay eligible educational expenses for higher education (i.e., college for you, your spouse, or the children or grandchildren of you or your spouse).
Exemption 2 – Inheriting an IRA
If you’re the non-spousal designated beneficiary of a deceased person’s IRA, amounts you withdraw from the inherited IRA are not subjected to early withdrawal penalties. To ensure the IRS knows withdrawals should not be subjected to the early withdrawal penalty, your IRA custodian/trustee should report the withdrawn amounts as death distributions.
Exemption 3 – Death
The IRA can simply be distributed penalty free at death. Most heirs with a sizeable IRA are reluctant to do this because the entire amount is subject to tax in the year of distribution. A more sensible approach is to take the IRA as an inherited IRA and work with a financial planner to withdraw the money over several years in order to minimize the rate of tax.
Providing money for a grandchild’s education from an IRA after death could be done without penalty under any of these three exemptions. Other situations can also qualify for exemptions to the early with penalty.
Exemption 4 — Purchase, building, or rebuilding of a first home ($10,000 lifetime limit)
First-time home buyers may withdraw up to $10,000, penalty free, to cover purchase costs including closing costs and fees. The IRS defines your home as a first-time home if you have not owned a home for the past two years. This $10,000 is once per lifetime—but if you are married, your spouse is also entitled an additional $10,000, giving a couple the opportunity to use $20,000.
Exemption 5 — Payment of medical insurance during a period in which you received unemployment compensation for at least 12 weeks
If you are unemployed, you may take penalty-free distributions from your IRA to pay for your medical insurance. In order for the withdrawal amount to be eligible for the penalty-free treatment, you must have lost your job and received unemployment compensation paid under federal or state law for twelve consecutive weeks during either the year you received the unemployment compensation or the following year.
Exemption 6 – Unreimbursed medical expenses in excess of 7.5% of your adjusted gross income
If you have un-reimbursed medical expenses from lack of health insurance, or more expenses than your insurance will cover, you may take penalty-free withdrawals from your IRA to cover these expenses. (Note, however, that only the difference between the amount of these expenses and 7.5% of your adjusted gross income is eligible.)
Exemption 7 — Permanent disability as defined by the Internal Revenue Code
If you are mentally or physically disabled, as determined and certified by a physician, and are unable to engage in any gainful employment, you are allowed to take penalty-free withdrawals from your IRA. You may have to provide your IRA custodian with proof of disability (a physician’s certification).
Exemption 8 — Distributions taken as a series of substantially equal periodic payments (72 (t) payments)
If you need to take money from your IRA for a few years, the IRS allows you to do so penalty-free if you meet certain requirements. You may withdraw the same amount periodically. That amount is determined by using one of three IRS approved methods, until you are either age 59 1/2 or for five years, whichever comes last. These calculations are relatively complex. If you are considering taking such withdrawals from your IRA, I strongly recommend you seek competent tax advice.
Exemption 9 — An IRS levy
The IRS will allow you to withdraw money from your IRA penalty free to pay a tax levy. Unfortunately, just like all the other exemptions, the withdrawal will be taxable in the year it was taken. Hopefully it will not result in another tax levy down the road creating an endless loop of taxes until your IRA is exhausted.
One final exception that does not result in taxation — money can be withdrawn from an IRA one time per year for up to 60 days without either penalty or tax. If the money is not back in the account by the 60th day—and the IRS accepts no excuses—all taxes apply. Keep in mind that if you violate the 60 day rule and the money is taken out before age 59 1/2, the 10% excise tax penalty will also be applied to the amount withdrawn.
- Generally, money withdrawn from a retirement account, regardless of the reason, is subject to income taxed as ordinary income.
- If the money is taken from an IRA before age 59 1/2, a 10% excise tax
penalty is applied to the amounts withdrawn unless it meets one of the nine
- Money can be withdrawn from an IRA one time per year for up to 60 days
without either penalty or tax. All the money has to be put back in the account by
the 60th day.