Surprisingly, many people don’t know that the IRS imposes a 10% penalty on what they call “early IRA distributions “. An “early distribution” is one that occurs before age 59 ½. In this post, you will learn the penalties associated with taking an early distribution from traditional IRAs, and how to avoid them. Roth IRAs, 401(k) plans, SIMPLE IRAs and other types of retirement plans often have different rules regarding early distributions.
Penalties? What penalties?
The IRS imposes a 10% penalty on IRA distributions if the IRA owner is under age 59 ½ at the time of distribution. The key phrase here is “at the time of distribution”. In other words you must really be age 59 ½ or older at the time of distribution in order to avoid the 10% penalty. Simply turning age 59 ½ during the calendar year in which you take a distribution is not enough.
What are the exceptions?
Below are 8 situations in which an early distribution penalty may be waived
1. Unreimbursed medical expenses that exceed 10% of your adjusted gross income. Thanks to Obamacare, unreimbursed medical expenses must exceed 10% of your adjusted gross income (AGI) to avoid the 10% penalty. The old rule was 7.5% of AGI. The exact calculation is the amount you paid for unreimbursed medical expenses less 10% of your adjusted gross income. For example, if your unreimbursed medical expenses are $15,000 and your adjusted gross income (line #37 on your 2012 1040 tax return) is $100,000, then the amount of your distribution that is not subject to the penalty is $5,000. $15,000 – $10,000 (10% of $100,000 AGI).
2. Medical insurance due to a period of unemployment. You may be able to avoid the 10% penalty on an early distribution if the distribution was to pay for medical insurance while you were unemployed. According to IRS publication 590, all of the following conditions must apply:
- You lost your job (obviously)
- You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job
- You received the IRA distributions during the year you received unemployment benefits or the following year
- You took your IRA distribution no later than 60 days after becoming re-employed
3. Disability. There is no penalty on distributions from an IRA if you are disabled and can prove that you are not able to do “any substantial gainful activity” due to your disability. This must be confirmed by a physician.
4. Death. When you die, your beneficiary may take distributions from your IRA that are taxable, but free of the 10% early distribution penalty.
5. “Series of Substantially Equal Periodic Payments”. Often referred to as SEPP payments or Regulation 72(t), the IRS allows penalty free distributions from traditional IRAs when the IRA owner is under age 59 ½, if the distributions are part of a “series of substantially equal periodic payments” over your lifetime. There are specific rules regarding how these payments must be calculated and when payments must be made. Failure to comply with the rules can result in the entire IRA becoming taxable and possibly subject to the very penalties you were trying to avoid.
6. Qualified educational expenses. IRA distributions made to pay for higher education expenses are generally not subject to the 10% penalty. The education related expenses may be for you, your spouse, you or your spouse’s children or even grandchildren. Qualified expenses include tuition, fees, books, supplies and equipment required by the school.
7. First home. Up to $10,000 may be distributed penalty free if used to buy, build or rebuild a first home if you meet certain qualifications. If you and your spouse both qualify, you may take up to $10,000 each for a first time home purchase without paying the 10% penalty. If you have not owned a home for two years or more before your new home purchase, you may qualify as a first-time home buyer.
8. Qualified reservist. If you were called to duty after September 11, 2001 and meet other requirements you may be able to avoid the 10% penalty on distributions that were made after you received a call to active duty.
As with most IRA rules there are not only exceptions but there are specific and often strict requirements that must be met in order to qualify for the exceptions. Regulation 72(t), for example, can be quite complicated. If you make an error, your entire IRA can blow up and become taxable and subject to additional penalties.
Of course, the best way to avoid penalties on your IRA is to avoid taking any distributions for any reason prior to your turning age 59 1/2. There are never penalties on IRA distributions taken after that time.
For more information, visit www.irs/gov and download IRS publication 590.
Required Disclosure: “IRA strategies implementing various tax strategies or tax codes may not be appropriate for all investors. Individual situations can vary, therefore, the information presented here should only be relied upon when coordinated with individual professional advice. This information is not intended to be a substitute for specific individualized tax, legal or estate planning advice.”