Taxpayers who need funds for an emergency may want to use their IRA. However, an early distribution can lead to a withdrawal penalty that may do more harm than good. Here’s what you need to know about the withdrawal penalty.
In this article:
- What Generally Triggers a Withdrawal Penalty?
- How to Avoid the Penalty for Early IRA Withdrawal
- Exceptions to the Early IRA Withdrawal Penalty
What Investors Need to Know About the Withdrawal Penalty and How To Avoid Them
What Generally Triggers a Withdrawal Penalty?
The most common reason why investors get a withdrawal penalty is an early, unqualified IRA withdrawal, according to the IRS IRA Withdrawal Resource Page. Taxpayers also need to add the withdrawal in the tax report that they had an IRA distribution for the tax year.
Not including the withdrawal in one’s tax report incurs additional fees. Taxpayers prefer to not to add the withdrawal in their tax file because the IRS will classify such withdrawals as income, which can lead to a higher adjusted gross income (AGI).
Most of the withdrawals from an IRA before reaching the age of 59½ carry a 10% penalty. This fee is in addition to the tax applicable, which is computed based on the gross income levels of the tax year the taxpayer withdraws funds.
Adjusted Gross Income Definition: This refers to a taxpayer’s total gross income minus specific deductions to income. Examples of these deductions (or “adjustments”) include allowable contributions to certain IRAs and alimony included in the gross income.
How to Avoid the Penalty for Early IRA Withdrawal
The most fool-proof way to not pay the penalty is simply waiting until one turns 59 ½.
Alternatives to Early IRA Withdrawal
Here are some alternative ways to avoid early IRA withdrawal, and ultimately, the penalty it will incur.
- Taking advantage of your credit by applying for a short-term loan can help.
- Finding other sources of money may also save the retirement account money.
- Proper budgeting for retirement can really help taxpayers avoid withdrawing early during their retirement investing phase.
Of course, there are qualified early withdrawals that will not impact the retirement account. By using these options, taxpayers can hold on to the retirement savings in their Traditional or Roth IRA.
Exceptions to the Early IRA Withdrawal Penalty
1. Withdrawing Money Due to Medical Expenses
For people who suddenly have medical emergencies without health insurance, the IRS can waive the penalties. However, the withdrawal must:
- Not exceed 10% of the taxpayer’s AGI, and
- If there ever is health insurance coverage, it cannot cover the expenses
For example, some health insurance may not cover pre-existing conditions.
However, if the insurance plan covers the medical expenses but in actuality, the patient pays for all of the medical expenses due to a deductible, then that deductible is not a qualified withdrawal. There may exist some exceptions to this case. However, it is best to err on the side of caution.
2. Taking Out Funds to Pay For Health Insurance Premiums
The IRS also allows withdrawals to pay for a health insurance plan. However, there are a few conditions that must be met in order for the IRS to waive the extra tax and fees.
- The taxpayer must have received 12 consecutive weeks of unemployment compensation.
- The beneficiary of the withdrawal is either the account holder, the spouse, or the dependents of the account holder.
- The taxpayer should report the distribution of the early withdrawal in the year or the year after the taxpayer received 12 weeks of unemployment benefits.
- Lastly, the use of the early withdrawal happened 60 days or more before the taxpayer found new employment.
3. Paying For a College Education
An IRA account holder can withdraw from his or her account balance to pay for a college education. This withdrawal can pay not only for tuition fees but also:
- Study materials
- Other items necessary for completing the degree
However, not all college institutions can make an early withdrawal qualified for exemption of penalties. The university or school should have eligibility to receive federal aid for the withdrawal to be exempt.
A word of caution is needed though: if the taxpayer opts to use his or her IRA to pay for college, this distribution increases taxable income. This higher income level not only means a higher AGI but also lowers the chances of receiving federal aid.
4. Buying the First Home
Anyone interested in living out the American dream of becoming a homeowner and hoping to purchase a first home with an early IRA withdrawal will probably get excited to learn that, yes, it’s also an exception.
The IRS allows an early withdrawal of 10% of the IRA’s account balance, up to $10,000. Couples have a higher limit of $20,000.
However, this distribution still has income taxes attached to it and can affect the taxpayer’s financial journey.
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5. Paying for Disabilities
Taxpayers encountering financial difficulties due to a disability can withdraw without penalties. Disability can be physical or mental, as long as proper documentation is presented.
Having a physician sign a medical certificate acknowledging the existence of the disability and its debilitating effects is required.
6. Account Holder in Active Duty
The IRS can also waive the early withdrawal penalty fee for people in military service.
To qualify, the taxpayer must be in active service at least 180 days before the withdrawal. Reaching 180 days means no 10% early withdrawal tax, but the income may have normal income taxes applied unless the taxpayer also qualifies for other military tax benefits.
7. Investment in an Annuity
Some self-directed IRAs have an annuity as part of an investment portfolio. Due to annuities having a scheduled distribution regardless of age or circumstance, the investor is forced to withdraw funds from the account.
The IRS understands this, and to help investors who have no choice but to withdraw, they have suspended the early withdrawal penalty. However, there must be at least one withdrawal for the year, and the amount should be based on the life expectancy of either the account holder, his or her spouse, or the beneficiaries.
Since the calculation of the life expectancy and the percentage yield to sustain the payout rate has complex formulations, taxpayers may find it better to talk to a financial expert on whether or not they want their IRA to have an annuity.
Withdrawing more or less than the amount calculated will lead not only to a higher tax bracket but also to penalties.
8. Withdrawing from a Roth IRA
Just to clarify, an early withdrawal from a Traditional IRA carries a 10% penalty on the contributions and income as well as an additional tax. On the other hand, an early withdrawal from a Roth IRA has penalties and taxes on only the income since the capital or contribution is taxed before the money enters the Roth IRA.
9. A Beneficiary Distributing Funds from an Inherited IRA
Roth IRA heirs can get early withdrawals without any kind of tax or penalty. However, Traditional IRAs have an income tax, as the money that the deceased deposited in the account has not been taxed yet.
However, if the heir younger than 59 ½ opted to claim the inherited retirement plan as his or her own, then early withdrawal penalties apply.
10. Leaving the Retirement Savings in a 401(k)
For the taxpayers who have retired at 55 or older, they can take advantage of their 401(k) without receiving a withdrawal penalty. However, if they opt to roll over the funds from a 401(k) to an IRA, then the funds can incur a penalty.
Taxpayers who qualify for any of these exceptions can save on fees if they opt for early withdrawals. It may sound complex, especially for someone who’s not overly familiar with the rules, but with the knowledge of how an IRA works, taxpayers and investors can make their retirement plans easier to execute.
Do you have any questions about IRA withdrawals? Let us discuss in the comments section below.
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