When it comes to IRA withdrawals, people often confuse tax-free and penalty-free.
When taxpayers younger than 59½ withdraw funds from a traditional IRA, Simplified Employee Pension (SEP) IRA, Savings Incentive Match Plan for Employees (SIMPLE) IRA, or Roth IRA, the withdrawal is usually 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 There are exceptions to the 10% penalty, but generally, money withdrawn from a retirement account, regardless of the reason, is subject to income tax. The most common exception is when the funds withdrawn are considered after-tax contributions.
Even when the withdrawal is considered taxable, the taxpayer may not owe any tax on the distribution, depending on their tax situation. The distribution could be sheltered by the individual’s deductions, resulting in no tax due. Unfortunately, if the withdrawal is subject to the 10% penalty, a tax penalty cannot be offset by deductions—a fact that catches many taxpayers by surprise.
Here’s the good news: there are 12 exemptions to the early withdrawal penalty.
Exemption 1 — Qualified higher education expenses
Penalty-free withdrawals are permitted to pay eligible higher education expenses for you, your spouse, or the children or grandchildren of you or your spouse. Eligible expenses include tuition, fees, books, supplies, and equipment. Room and board also count if the individual attending college is at least a half-time student. Qualifying institutions include colleges, universities, and vocational schools eligible to participate in federal student aid programs. Check with the school to make sure it satisfies the requirements to be part of the program.
Exemption 2 – Inheriting an IRA
If the heir is a non-spousal designated beneficiary of a deceased person’s IRA, withdrawals from the inherited IRA are not subjected to early withdrawal penalties. If the original account owner passed away after January 1, 2020, a beneficiary is required to withdraw all assets from the inherited IRA within ten years of the IRA owner’s death. There are exceptions to the 10-year rule when the heir is a surviving spouse, minor child, disabled, chronically ill, or up to 10 years younger than the original account owner. The IRA custodian should report the withdrawal as a death distribution by including code “4” in box seven of the IRS Form 1099‑R, the form used to report the distribution.
The 10% penalty exemption does not apply when the beneficiary is the spouse of the original account holder and the sole beneficiary when a spousal transfer is elected. A spousal transfer is when the inherited IRA is rolled over into a non-inherited IRA. In this situation, the 10% early withdrawal penalty would still apply.
Exemption 3 – Death
An IRA can 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 to minimize the tax rate.
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 ($20,000 for couples). The IRS defines a home as a “first-time home” if the taxpayer has not owned a home for the past two years. If the home’s purchase or construction is canceled or delayed, the money can be put back in the IRA within 120 days of the distribution to avoid the penalty. This type of early IRA withdrawal can also be used to help purchase a first home for a child, grandchild, or parent. The $10,000 exemption is once per lifetime.
Exemption 5 — Payment of medical insurance during a period in which unemployment compensation is received for at least 12 weeks
If unemployed, one may be eligible to take penalty-free distributions from an IRA to pay for medical insurance. For the withdrawal amount to be eligible for the penalty-free treatment, certain conditions must be met by the taxpayer:
- They must have lost their job.
- They must have received unemployment compensation paid under federal or state law for twelve consecutive weeks.
- They must have taken the distributions during either the year the unemployment compensation was received or the following year.
- They must have taken the distribution before having been re-employed for 60 days or more.
Exemption 6 – Unreimbursed medical expenses over 7.5% of adjusted gross income
If a taxpayer has unreimbursed medical expenses from lack of health insurance or more expenses than insurance will cover, penalty-free withdrawals may be available from an IRA to cover these expenses. (Note, however, that only the difference between the amount of these expenses and 7.5% of the adjusted gross income is eligible.) One needn’t itemize deductions to take advantage of the penalty exception for medical costs. To qualify, the medical expenses must be paid during the same calendar year the withdrawal is taken.
Exemption 7 — Permanent disability as defined by the Internal Revenue Code
If a taxpayer is mentally or physically disabled, as determined and certified by a physician, and unable to engage in any gainful employment, penalty-free withdrawals may be available from an IRA. Documentation of the inability to participate in gainful activity due to the condition may need to be provided. A physician will need to determine the severity of the disability. Conditions that qualify for the penalty exemption are generally expected to be of long, continued, or indefinite duration or result in death. The distribution can be used for any purpose.
Exemption 8 — Distributions taken as a series of substantially equal periodic payments (72 (t) payments)
If money is withdrawn from an IRA over the course of a few years, the IRS allows it to be done penalty-free if certain requirements are met. The periodic withdrawal must be the same amount each year, and that amount is determined using one of three IRS-approved methods until the taxpayer is either age 59½ or for five years, whichever comes last. These calculations are relatively complex. For anyone considering taking such withdrawals from an IRA, I strongly recommend seeking competent tax advice. If the correct amount is not consistently withdrawn over the appropriate number of years, penalties could be applied.
Exemption 9 — An IRS levy
The IRS can draw on an IRA to pay a taxpayer’s tax bill if there are unpaid federal taxes. Unfortunately, just like all the other exemptions, the withdrawal will be taxable in the year taken. Hopefully, it will not result in another tax levy down the road, which could create an endless loop of taxes until your IRA is exhausted. The 10% penalty won’t apply if the IRS levies the money directly. However, a taxpayer cannot withdraw the money to pay the taxes to avoid the levy.
Exemption 10 — The birth or adoption of a child
Since 2020, parents of newborns are eligible to take penalty-free IRA distributions. IRA owners can withdraw up to $5,000 without penalty following the birth or adoption of a child. The distribution must be taken within one year of a child’s birth or adoption. If financial circumstances improve, parents have the option to put the money back into the account to accumulate for retirement.
Exemption 11 — Withdrawal for military service
Qualified reservist distributions may be available to members of the Air Force Reserve, Air National Guard of the United States, Army National Guard of the United States, Army Reserve, Coast Guard Reserve, Marine Corps Reserve, Naval Reserve, or Reserve Corps of the Public Health Service. Members of the military reserves who take an IRA distribution during active duty are not subject to the 10% penalty on the amount withdrawn. The penalty exception is available to those ordered or called to duty for more than 179 days. The distribution must be taken during the active-duty period to avoid the penalty. In some cases, the distributions can be repaid, even if the repayment contributions exceed annual contribution limits. However, you must do so within two years of the end of active duty.
Exemption 12 – Once per year 60-day rollover
Money can be withdrawn from an IRA one time per year for up to 60 days without penalty or tax. The withdrawn funds are taxable if the money is not back in the account by the 60th day. If you exceed the 60-day period and the money is taken out before age 59½, the 10% excise tax penalty will also be applied to the amount withdrawn.
Even though the circumstances above are exempt from the early-distribution penalty, they still may be subject to federal and state tax. A trusted tax professional can determine what taxes might be owed and help complete the appropriate forms. To claim the early-distribution penalty exception, IRS Form 5329 may be required along with that year’s income tax return—unless the IRA custodian reports the amount as being exempt on IRS Form 1099‑R.
Other options to get access to funds, such as taking out a personal loan, may be available.
Insights
- Generally, money withdrawn from a retirement account is subject to income tax regardless of the reason.
- If the money is taken from an IRA before age 59½, a 10% excise tax penalty is applied to the amounts withdrawn—unless it meets one of the twelve exceptions.
- Money can be withdrawn from an IRA one time per year for up to 60 days without penalty or tax. All the money has to be put back in the account by the 60th day.
Originally posted February 2012
