Exceptions to the 10% Penalty on Early IRA Withdrawals
Last week, we focused on using the 60-day IRA rollover rule to help ease a financial burden while avoiding income taxes normally owed on a traditional IRA distribution. However, sometimes the financial need is such that a rollover just won't work. You need the money out of your IRA, and won't be able to put it back in during the 60-day rollover period.
In such cases, income taxes will be owed on the most if not all the distribution, and as pointed out last week, if the distribution is made prior to reaching age 59½, you may also be subject to a 10% early withdrawal penalty. While there really is no way to avoid the income tax, there are some exceptions to the penalty.
If you find yourself in an unavoidable situation of having to take an IRA distribution early, knowing these exceptions can help you plan to minimize the damage. Let's take a look at what they are:
1. Medical expenses. If you have qualified medical expenses in excess of 7.5% of your adjusted gross income, early IRA withdrawals up to the amount of that excess are exempt from the penalty. To qualify, these expenses must be paid in the same year during which you take the early withdrawal.
2. Health insurance during unemployment. Closely related to the above, this exception is available to an IRA owner who has received unemployment compensation for 12 consecutive weeks under a federal or state unemployment law during the current year in question or the preceding year. If this condition is satisfied, the IRA owner's early withdrawals during the year in question are penalty-free up to the amount paid during that year for health insurance premiums to cover the IRA owner, his or her spouse and dependents. Note, once the IRA owner has regained employment for at least 60 days, this exception no longer applies.
3. Disability. This exception applies to amounts paid to an IRA owner who is physically or mentally disabled to the extent that he or she cannot engage in his or her customary paid job or a comparable one. In addition, the disability must be expected to:
- Lead to death, or
- Be of long or indefinite duration (but not necessarily expected to be permanent).
4. Death. Amounts withdrawn from an IRA after the IRA owner's death are generally penalty free. This exception isn't available for funds rolled over into a surviving spouse's IRA or if the surviving spouse elects to treat the inherited IRA as his or her own account. There is a workaround for a surviving spouse that needs some of the inherited funds. In that case, the surviving spouse should leave the funds in the inherited IRA (in other words, the original one set up for the deceased spouse). Then, the surviving spouse can withdraw the needed funds from the inherited IRA without any penalty.
5. Substantially equal periodic payments (SEPPs). These are annual annuity-like withdrawals that must be taken for at least five years or until you reach age 59½, whichever comes later. The rules for SEPPs are fairly complicated, so make sure you get professional financial help to avoid problems.
6. First-time home purchases. This exception allows penalty-free IRA withdrawals to the extent the money is spent by the IRA owner within 120 days to pay for qualified acquisition costs for a principal residence. This isn't an unlimited exception, however, as there is a lifetime $10,000 limit. The principal residence can be acquired by the IRA owner, the IRA owner's spouse, the IRA owner's child, grandchild or grandparent, or the spouse's child, grandchild or grandparent.
The buyer of the principal residence (and the spouse if the buyer is married) must not have owned a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are those incurred to acquire, construct or reconstruct a principal residence, including closing costs.
7. Qualified higher education expenses. Penalty-free early IRA withdrawals can be made to the extent of qualified higher education expenses paid during the same year. The expenses must be for the education of the IRA owner, or the IRA owner's spouse, or a child, stepchild or adopted child of the IRA owner or the IRA owner's spouse.
8. Military reservists called to active duty. This exception applies to early IRA withdrawals taken by military reserve members who are called to active duty for at least 180 days or for an indefinite period.
9. IRS levies. Early IRA withdrawals taken to pay IRS levies against the IRA account itself are excepted from penalty. Notice the nuance here. The exception is not available when the IRS levies against the IRA owner (as opposed to the IRA itself), and the owner then withdraws IRA funds to pay the levy.
There you have it, nine exceptions to the IRA early withdrawal penalty. I always recommend using early IRA withdrawals only as a last resort. But if you the need arises, knowing these rules and making sure you qualify may help ease your burden just a bit.
Lane Keeter, CPA, is Office Managing Partner of the Heber Springs office of EGP, PLLC, CPAs & Consultants (a full-service financial firm with offices in Heber Springs, North Little Rock and Bryant) and past winner of The Sun-Times Reader's Choice Award for Best Accountant.