Your Individual Retirement Account (IRA) is a savings account for your future. Ideally, you contribute money to it annually and watch it grow until you retire. The money in your IRA is yours, but in a way, it is locked up until you are 59 and a half years old. You can access it before then, but you may need to pay a fee to do so. If you need to withdraw some amount from your account, you’ll have to include it in your gross income and pay an additional 10% tax – most of the time.
Reasons for Early Withdrawal
The best approach is to let your IRA grow as long as you can. The 10% tax on early withdrawals helps prevent people from taking money from these accounts to meet short-term or non-emergency needs.
“We teach people that saving for retirement is the last resort they should turn to [in emergencies],” said Katie Lewis, a tax preparer and investment advisor at Financial Security Management Inc. in Lakewood, Colorado, in a phone interview with The Balance. “If one of our clients brings up this issue, we look at all their other assets and see if we can find a creative solution where they don’t have to tap into their retirement savings.”
The penalties are woven into tax laws. But lawmakers understand that life happens. Job loss, disability, health issues, and other events can make it difficult to earn enough money to live on. Because of these events that are beyond people’s control, the Internal Revenue Service allows you to make early withdrawals from your accounts for certain reasons without incurring fees or taxes. The IRS classifies these reasons as hardship distributions.
Common Exceptions to Early Withdrawal Penalty
Here are the most common reasons for early withdrawal from most retirement accounts without incurring the 10% additional tax.
Education
If you withdraw money to cover higher education expenses in the same tax year, you won’t owe tax on it. The education expenses must be for you, your spouse, children, or grandchildren.
Medical Expenses
You can withdraw money from your IRA for certain medical expenses. The bills must exceed 7.5% of your adjusted gross income (AGI). You will also need to pay them in the same tax year in which you withdrew the funds.
First-Time Home Purchase
If you are buying, building, or rebuilding your first home, you can withdraw money from your IRA for home purchase costs, including closing costs. You must spend the money on the home within 120 days of withdrawing it. You can also use the funds to buy, build, or rebuild a home for your child, grandchild, parent, grandparent, or any other ancestor. There is a lifetime limit of $10,000 for first-time home purchases. If you are married, both you and your spouse can each withdraw $10,000.
Birth or Adoption
New parents can withdraw up to $5,000 to cover birth or adoption expenses. You have up to one year after the birth or adoption to withdraw the amount. Also, you are allowed to recontribute an amount equal to the withdrawn amount to your plan, in addition to regular contributions.
Health Insurance
If you have received unemployment insurance payments for at least 12 weeks, you can withdraw funds from your retirement account without penalty to pay for health insurance premiums for yourself or your dependents.
Disability
You can withdraw from your IRA if you become physically or mentally disabled. Your doctor must document this, and the condition must prevent you from working or participating in any form of profitable work.
Death
You can…
Beneficiaries can withdraw funds without paying the additional 10% tax upon death. However, if they transfer the funds to a survivor IRA or start contributions to it, those funds cannot be used for early withdrawal without incurring additional taxes.
Military Exceptions
If you are a member of the military reserve or National Guard, or a member of the Public Health Service, you can withdraw money from your account if activated. You must be called to service for at least 180 days. This is referred to as qualified reservist distributions.
Money Owed to the Internal Revenue Service
If you have overdue taxes, the IRS can place a lien against your IRA account. There will be no early withdrawal penalty as long as the IRS directly removes the funds.
Substantially Equal Periodic Payments (SEPPs)
The SEPP program allows you to take early withdrawals from an IRA or retirement plan without the 10% penalty. One problem with SEPPs is that the rules are complex and require a financial professional to help you choose the right type of withdrawals and plan.
Under a SEPP plan, you must withdraw annual payments from your account for five consecutive years or until you reach age 59 and a half, whichever comes later.
Special Circumstances
You may be able to withdraw money from your IRA account if special circumstances financially affect many individuals. For example, the COVID-19 pandemic caused many people to lose their jobs or become unemployed, prompting Congress to pass a law allowing individuals to access funds in their IRA accounts to help pay bills without penalty.
Note: If there is an event affecting many people financially, look for any new laws that may allow early withdrawals from your IRA account.
Alternatives to Tapping into an IRA for Funds
It’s always best to exhaust all other options before withdrawing funds from your IRA. This is because you need compound interest growth over several years; you need enough to rely on in retirement. Withdrawing funds diminishes the growth rate at which your money can accumulate.
In addition to borrowing from a 401(k) plan and paying it back later, you have other options. Some may include getting a low-interest loan from a bank or credit union. You can also consider refinancing your home mortgage or obtaining a home equity loan if your home value has increased in the market. You could also take on a side job to earn extra income if you have the time.
Key Takeaways
- There are many reasons you can withdraw money from an IRA or retirement account before age 59 and a half without paying the additional 10% tax.
- If you can avoid it, withdrawing money from your IRA should be your last resort.
- Early withdrawals from most IRA accounts are still subject to income tax in addition to the additional 10% tax.
- If you have a Roth IRA, you can access your contributions (not your earnings) without penalty since taxes have already been paid on those amounts.
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Sources:
Source: Internal Revenue Service. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs),” Pages 14, 24, and 30.
Source: Internal Revenue Service. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs),” Page 25.
Source: Internal Revenue Service. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs),” Page 26.
Source: Internal Revenue Service. “Safe Harbor Explanations – Eligible Rollover Distributions,” Pages 3-4.
Source:
Internal Revenue Service. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs),” Pages 30-31.
Source: Internal Revenue Service. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs),” Page 25.
Source: govinfo. “26 U.S. Code § 72. Annuities; Certain Proceeds of Endowment and Life Insurance Contracts,” Page 396.
Source: Internal Revenue Service. “Retirement Plans FAQs Regarding Substantially Equal Periodic Payments.”
Source: Internal Revenue Service. “Coronavirus Relief for Retirement Plans and IRAs.”
Source: https://www.thebalancemoney.com/avoid-the-early-withdrawal-fee-on-your-ira-356290
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