Ways to Avoid the 10% Early Withdrawal Fee on Your IRA
Investing for retirement through a Traditional IRA, Rollover IRA, SIMPLE IRA, SEP- IRA, or Roth IRA offers investors extraordinary tax benefits. However, those massive benefits come with a price. As many investors know, if you make an early withdrawal from any of those accounts, you can get hit not only with federal, state, and local taxes, but an additional 10% penalty in the form of an early withdrawal fee payable to the IRS as punishment for raiding the reserves meant for old age.
For Traditional IRAs, Rollover IRAs, SIMPLE IRAs, and SEP-IRAs, the early withdrawal penalty typically hits from the first dollar of withdrawals. Roth IRAs, on the other hand, are funded with after-tax dollars so you are allowed to withdrawal all of your past principal contributions, and only once you've begun pulling down additional amounts from capital gains, dividends, interest, and other investment income do you get hit with an early withdrawal penalty.
Early Withdrawal Penalties
How old, you might ask, do you have to be for your withdrawals not to incur early withdrawal penalties? Simple. Early withdrawal for the sake of IRA penalties is set at any time before the IRA beneficiary is 59.5 years old. This may seem unfair. After all, it's your money.
The reason the early withdrawal fee is assessed on IRAs and certain other types of retirement accounts is because Congress wanted to discourage individuals from draining their investment capital today to solve some short-term problem if it meant later, in old age when they could no longer work, they would become dependent upon various forms of welfare.
In olden times when pensions were more common, this wasn't possible — a person would declare bankruptcy and have to start over while almost always retaining his or her pension rights. Once we went to a do-it-yourself retirement system, the wealth gap between those who can handle money and those who can't be exploded as individual decisions coupled with the power of compounding resulted in exponential differences in outcomes.
In other words, the IRA early withdrawal fee was the stick to the carrot our legislative and executive branch extended when it passed the respective laws establishing these retirement accounts. Follow the rules and you reap major rewards. Violate them and suffer the consequences.
Nevertheless, if you are intent on tapping your retirement portfolio before it is time — and make no mistake, it is almost always a bad idea to make early withdrawals from your retirement portfolio — here are the ways you might be able to avoid the early withdrawal fee, saving yourself that extra 10% of which you would have otherwise had to part.
Becoming Permanently Disabled
If you become permanently disabled, such as by sickness or an accident, and it renders you incapable of earning gainful employment and supporting yourself, you can avoid the 10% early withdrawal penalty on your IRA. You need to get a physician to certify that you are physically or mentally incapable of working and that the condition is either going to last 1) a significant length of time, 2) an indeterminant length of time, or 3) eventually lead to your death.
Though I'm sure it's cold comfort, if you are unfortunate enough to pass away before you reach the age of 59.5 years old, your estate or beneficiaries won't be hit with the 10% early withdrawal penalty on your IRA or IRAs.
The rules for inherited IRAs can seem complex, but in many cases, those who inherit your retirement funds can either combine them with their own IRAs (in the case of your husband or wife as this is one of the many financial benefits of marriage), put them into an inherited IRA of their own which might allow for a five-year extension of forced withdrawal starting from the end of the year in which you passed away allowing them to enjoy their own tax-deferred compounding, or be disbursed immediately, in which case only ordinary income taxes are due.
Using IRA Funds to Pay Non-Reimbursed Medical Expenses
If you or your children are seriously ill or injured and are hit with prolonged or expensive medical treatment, Uncle Sam will waive the early withdrawal fee on your IRA on the condition that the expenses are in excess of 7.5% of your adjusted gross income.
First-Time Home Buyers Can Avoid the Early IRA Early Withdrawal Fee
If you are looking at buying your first home, the 10% early withdrawal penalty is waived on up to $10,000 of withdrawals that would have otherwise been subject to it. Of course, it is almost always better to hang on to the incredible tax advantages of the IRA and, instead, build up your down payment money in an appropriate investment outside of and separate from your retirement assets — and "better" is a significant understatement — but not everyone is that patient.
Covering Higher Education Costs
Attending college or university can be expensive. Thankfully, there are some rules in effect designed to help successful families pay for their relative's education. For example, certain qualifying education costs are exempt from the gift tax, allowing affluent and high net worth parents and grandparents to invest in the human capital, knowledge capital, and network capital of their heirs without treating it like a financial gift that would otherwise trigger the gift tax or a reduction in the lifetime estate tax exemption limit.
Specifically, the 10% early withdrawal penalty does not apply to IRA distributions as long as the total amount is withdrawn doesn't exceed the qualified expenses incurred by the taxpayer, his or her husband or wife, their children, or their grandchildren and the money is spent at a qualified educational institution, which includes those described in section 481 of the Higher Education Act of 1965 such as colleges, universities, vocational schools, and some other training programs.
Not all expenses are eligible for this special treatment — the college or university only requires the student to pay for their own tuition, fees, supplies, equipment, and textbooks. Room and board isn't covered under the definition of expenses unless the student is enrolled full-time, creating a bigger hurdle for those who work their way through school.
This particular early withdrawal penalty exemption is not as simple as it appears due to the fact there are calculations involving other sources of education funding that must be done to determine the exact extent to which an IRA beneficiary can avail himself or herself of it. This is definitely an area to consult with a qualified accountant, tax specialist, or financial advisor. You may also want to read Notice 97-60 from the Internal Revenue Service to get a rundown of the rules.
Paying Back-Taxes Owed to the IRS After a Levy Has Been Placed Against the IRA
If you owe the government money and they are successful at getting a levy placed against your IRA, ultimately raiding it to pay the taxes you owe, the forced withdrawals will be subject to regular income taxes to the extent they otherwise would have been, but the additional 10% early withdrawal penalty isn't assessed.
Paying Medical Insurance Premiums
If you find yourself out of a job or, for some other reason, in a position where you have to pay your own medical insurance premiums, you can tap your retirement funds to cover the expense and not worry about the 10% early withdrawal penalty as long as you've been on unemployment for longer than twelve weeks.
Withdrawals Made on or After the Day the IRA Beneficiary Turns 59.5 Years Old
Finally, we arrive at the last early withdrawal penalty exemption for IRA owners and it is the one to which you should aspire: Living to 59.5 years old, at which point you can begin drawing down your account. This is the point at which you've crossed the finish line and are considered sufficiently close enough to retirement age that you don't need to worry about it.
Before You Make an Early Withdrawal from Your IRA
If you are thinking of making an early withdrawal from your IRA, make sure you consult with a qualified accountant, professional, registered investment advisor, or other professionals because the rules can be tricky.
For example, the beneficiary of an IRA is subject to a five-year waiting period, measured in tax, not calendar, years during which a withdrawal cannot be exempt from the early withdrawal penalty even if it otherwise would have been.
There are rules unique to employees recently enrolled in a SIMPLE IRA at a small business that penalize you, even if you are 59.5 years old if you make withdrawals within a certain number of years following enrollment in the plan.
There are certain Roth IRA withdrawals that might be exempt from the early withdrawal penalty but can actually cause you to be subject to income tax even when you ordinarily wouldn't have been. This is one of those situations where details matter and you need to know all of them.