Ways You Can Make an Early Withdrawal From Your IRA Without the Fee
Investing for retirement through a traditional IRA, rollover IRA, SIMPLE IRA, SEP-IRA or Roth IRA offers investors extraordinary tax benefits. In most cases, you can use the amount of the contribution to reduce the amount of tax you pay each year and the investment earnings will be completely tax-deferred until you're ready to start drawing from on the account.
Early Withdrawal Penalty Lifted
One of the steps the government has taken in response to the coronavirus pandemic is to lift the penalty for early withdrawals from retirement savings accounts like IRAs and 401(k)s:
- Withdrawals are capped at $100,000
- Withdrawal income is taxable at the usual rate (but may be paid over three years)
- Funds may be recontributed without respect to annual contribution limits
The CARES Act also relaxed rules around borrowing from eligible retirement accounts and lifted required distribution rules for those aged 70-1/2 or older. For more information, see the IRS' coronavirus tax relief page.
However, these benefits come with a price. As many investors know, if you make an early withdrawal from any of these accounts, you not only get hit with federal, state, and local taxes, but an additional 10% penalty in the form of an early withdrawal fee. This fee is 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 starts from the first dollar of a withdrawal. Roth IRAs, on the other hand, are funded with after-tax dollars so you are allowed to withdraw all of your past principal contributions. Once you start pulling 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 beneficiary is 59.5 years old. This may seem unfair. After all, it's your money. But there is a very good reason why a penalty is imposed.
The reason the early withdrawal fee is assessed on IRAs and other retirement accounts is because Congress wanted to discourage individuals from using their retirement funds to solve a more immediate, short-term problem. Doing so today may mean people would become dependent on various forms of welfare later in old age.
This wasn't possible when pensions were common. 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 exploded, as individual decisions coupled with the power of compounding resulted in exponential differences in outcomes.
In other words, the early IRA withdrawal fee was the stick-to-the-carrot our legislative and executive branch extended when it passed the laws establishing these retirement accounts. The basic message was: 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 a few ways you may be able to avoid the early withdrawal fee, and save yourself the extra 10% which you would have otherwise lost.
Paying 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 more than 7.5% of your adjusted gross income (AGI).
Qualified expenses include anything related to the diagnosis, cure, treatment or prevention of a disease. They can also include payments for treatments that affect any part or function of the body.
A full list of deductible medical expenses can be found on the IRS website.
First-Time Home Buyers
If you are looking at buying your first home, the 10% early withdrawal penalty is waived on up to $10,000. Of course, it is almost always better to hang on to the incredible tax advantages of the IRA and build up your down payment in an appropriate investment outside your retirement assets. But not everyone is that patient, and not everyone has the resources to save that extra cash.
Higher Education Costs
Attending college or university can be expensive. Thankfully, there are some rules designed to help successful families pay for a relative's education. For example, certain qualifying education costs are exempt from the gift tax. This allows affluent and high net worth parents and grandparents to invest in the education 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 withdrawn doesn't exceed the qualified expenses incurred by the taxpayer, a spouse, children or grandchildren, and the money is spent at a qualified educational institution. A complete list can be found 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 because 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 (IRS) to get a rundown of the rules.
Back-Taxes to the IRS
You won't be penalized with the 10% early withdrawal fee if you owe the government money and it gets a levy ]against your IRA. By raiding your retirement account to pay back the taxes you owe, you will only be subject to regular income taxes.
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.
The situations listed above are not the only ones that qualify for an exception to the 10% early withdrawal fee. Here are some of the other circumstances:
- Distributions to qualified military reservists called to active duty
- Excess contributions if withdrawn by extended due date of return
- Permissive withdrawals from a plan with auto enrollment features
The full list of which circumstances are exempt from the 10% fee and which are not are available here. The list also outlines which situations are exempt in 401(k) and other retirement plans.
After Age 59.5
Finally, we arrive at the last early withdrawal penalty exemption for IRA owners. This 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.
The Bottom Line
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 professional 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.