Three out of four Americans are saving for their retirement through an IRA, 401(k), or another type of retirement account. Although these funds are meant to be used later in life, sometimes unexpected events can throw a wrench in those plans. Take for example the coronavirus pandemic. In 2020, nearly 33% of those with a retirement account withdrew or borrowed money from it to help ease their financial strains. Thankfully, the CARES Act offered special allowances for taxpayers who needed to dip into their retirement savings. Those rules, however, do not apply in 2021. If you need to take out your money before you retire, keep in mind that there are rules for IRA early withdrawals and tax penalties associated with them.
IRS Early Withdrawal Penalty
In general, if you take money from your retirement savings account before you reach the age of 59 ½ you’ll face an early withdrawal penalty of 10 percent. You can withdraw Roth IRA contributions, however, at any time without paying taxes or penalties. The earnings, however, would incur a 10% penalty unless they are five years or older. An early withdrawal from a traditional IRA will trigger the penalty unless it falls under IRS hardship rules.
What is an IRA Hardship Withdrawal?
Per the IRS, a hardship withdrawal is “one used to help alleviate an immediate and heavy financial need.” It is also limited to the amount needed to satisfy that need. The money is taxed as income, and you are not required to place it back into your retirement account. An IRA hardship withdrawal, however, will not incur the 10% early withdrawal penalty.
IRA Early Withdrawals That Qualify For Hardship
Although some employer-sponsored retirement accounts may not allow hardship withdrawals, a traditional IRA provides many instances where you can take a penalty-free withdrawal.
You may withdraw money penalty-free from your IRA to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI). This includes medical fees to diagnose, prevent, or treat an illness, including those related to dental or vision issues. To determine how much you can withdraw, simply follow this formula:
(unreimbursed medical expenses) – (7.5% AGI) = allowable amount
Keep in mind that the withdrawal must take place during the same year your medical expenses were incurred. Fortunately, you are not required to itemize deductions to avoid paying the 10% early withdrawal penalty.
Were you recently found to be totally and permanently disabled? The IRS will allow you to take early distributions from your IRA account without penalty. You will need to prove your disabled status, which can be done by collecting payments from your insurance company or through Social Security.
Health Insurance Premiums
Need money to help cover health insurance premiums for yourself, your spouse, or dependents? If you’ve been unemployed for a minimum of 12 weeks, you can make penalty-free withdrawals from your IRA. To avoid potential issues from a tax audit, we suggest keeping the money in a separate account or sending the money directly to the insurance provider.
The IRS allows those with traditional IRAs to cover certain higher education expenses without incurring the early withdrawal penalty. In general, the following post-secondary expenses are eligible:
- Room and board (meals)
- Books and other supplies required for enrollment
The fees may be for you, your children, or other immediate family members. The qualified expenses must also be paid in the same year you took the withdrawal. The person benefiting from the funds must also be enrolled at least half-time and pursuing a degree.
Please note that your IRA distribution may affect the student’s financial aid eligibility and could lessen the amount of scholarship or grant money offered. It’s a good idea to consult with a financial advisor before moving forward with this type of IRA hardship withdrawal.
Other Ways to Avoid the 10% Penalty
There are other ways to avoid the 10% early withdrawal penalty when removing money from your traditional IRA.
If you owe the IRS, they may place a levy on your IRA account to pay off your tax debt. When this happens, you will not incur the 10% early withdrawal penalty.
First-Time Home Purchase
Unlike a 401(k), you can use money from your traditional IRA to make the down payment on a home and not be hit with an early withdrawal penalty. Although it’s categorized as a “first-time” homebuyers exemption, those who have owned a home previously are not excluded. As long as you haven’t owned a home within the last two years, you can withdraw up to $10,000 (lifetime limit). If you’re married, your spouse can contribute an additional $10,000 through their IRA, as well.
Substantially Equal Periodic Payments
The IRS allows you to make penalty-free withdrawals from your IRA if you meet the conditions under Section 72(t) of the tax code. The distribution amount is calculated using one of three IRS-approved methods: amortization, annuitization, or required minimum distribution. You will be required to take substantially equal periodic payments over five years or until the age of 59 ½, whichever is longer. If you decide to cancel the plan before the time expires, you’ll be required to pay all waived penalties plus interest.
Are you a member of the military reserves? You may be able to avoid the 10% early withdrawal penalty if:
- You were placed on active duty status for more than 179 days; and
- The distribution was taken during the active duty period.
This penalty exemption is available to members of the Army Reserve, Coast Guard Reserve, Marine Corps Reserve, Navy Reserve, Air Force Reserve, Air National Guard, Army National Guard, and the Reserve Corps of the Public Health Service.
Adoption or Birth of a Child
If you have a traditional IRA, you may now take up to $5,000 without penalty for the birth or adoption of a child, as long as the distribution is made within the first year following the adoption or birth.
When an IRA account holder dies, the beneficiaries may make penalty-free withdrawals from the account. If you are the spouse, however, be very careful. The IRS imposes strict restrictions, and you could be forced to pay the 10% early penalty if you treat the account as your own.
Not all retirement accounts are treated equally. If you have a 401(k), you may or may not be eligible for a hardship withdrawal. And, in some cases, the withdrawal may still be subject to an early withdrawal penalty. Even if penalties are waived, you may still owe state and federal income taxes.
Before taking any IRA early withdrawals, speak with an experienced tax professional. They can help you determine your potential tax consequences and assist with completing the required forms.