Avoiding the 10% IRA Early Withdrawal Penalty – What every Traditional IRA owner should know
While it is not a good idea to tap retirement accounts prior to retirement age, sometimes it cannot be avoided. What can often be avoided, however, is the punitive 10% penalty for early fund distributions. Outlined here are exceptions to the 10% penalty rule for Traditional IRAs
Avoiding the 10% IRA Early Withdrawal Penalty
It is one thing to be taxed on retirement contributions and their related earnings when you withdraw funds from your Traditional IRA during retirement, it is quite another when you pay the tax PLUS a 10% penalty for early withdrawal. There are cases when funds needed prior to retirement can avoid this early withdrawal penalty. Here are ten of them.
- Medical insurance premiums if unemployed. If you have been receiving federal or state unemployment for 12 or more consecutive weeks, you may pay for medical insurance premiums from your Traditional IRA without paying the 10% early withdrawal penalty. The premiums may cover yourself, your spouse, and your dependents’ medical insurance premium.
- Qualified higher education expenses. You may pay for tuition, books, fees, supplies, and equipment at a qualified post-secondary institution for yourself, your spouse, your child or grandchild from your Traditional IRA. Just be aware of the potential impact this may have on financial aid and other educational tax benefits.
- Medical expenses. If you need to withdraw from your IRA to fund medical expenses in excess of 10% of your Adjusted Gross Income you may do so penalty-free.
- First-time homebuyer expenses. IRA distributions of up to $10,000 to help pay for the qualified acquisition costs of a first-time home avoid the early withdrawal penalty too. The $10,000 is a lifetime limit per individual and not per home purchased. A first-time homebuyer is defined by the IRS as not having an ownership interest in a principal residence for two years prior to your new home acquisition date. Even better, to qualify the home can be for you, your spouse, your child, your grandchild, your parent or even other ancestors.
- Conversions of Traditional IRAs to Roth IRAs. Want to convert your Traditional IRA into a Roth IRA to avoid paying taxes on future account earnings? No problem, this too is considered a qualified event to avoid the 10% penalty.
- You’re the beneficiary. If you are the beneficiary of someone else’s IRA and they die, there is usually an opportunity to withdraw funds without the penalty. Plenty of caution is required in this case, because if treated incorrectly the penalty might apply.
- Qualified reservist. If you were called to active duty for more than 179 days, amounts withdrawn from your IRA during your active duty can also avoid the 10% penalty.
- Annuity distributions. There is also a way to avoid the 10% early withdrawal penalty if the distributions “are part of a series of substantially equal payments over your life (or your life expectancy)”. This option is complicated and must use an IRS-approved distribution method to qualify.
- Permanently disabled. There is no penalty for early withdrawals if you become permanently disabled.
- Age 59 1/2. Of course, there also is no longer an early withdrawal penalty when you reach age 59 1/2.
Some final thoughts
- While the above events allow you to avoid the 10% early withdrawal penalty you will still need to pay the income tax due on the withdrawn funds.
- While generally the same, the 10% early withdrawal penalty rules are slightly different for other defined contribution plans like 401(k)s and other types of IRAs.
- Before taking any action, call to have your situation reviewed.