Contributed by: PhillipB, FreeTaxUSA Agent, Tax Pro
Most current retirement plans are designed for you to keep money in the account so that the funds accumulate to provide income when you retire. For that purpose, the 10% early distribution penalty was enacted. If a taxpayer takes money out of their retirement account before age 59.5, they generally need to pay both a penalty tax and income tax on the money. In some cases, the withdrawal could be subject to 30% or 40% in total tax.
Reasons you can take money out early
However, as with most tax issues, there are many exceptions to this rule. Most exceptions are to help people fund important events, or get relief from disasters or unforeseen changes in life circumstances. Besides an exception to the early withdrawal penalty if a taxpayer is actually 59.5 years old at the time of the distribution, the list of exceptions to the early withdrawal penalty is below:
- Automatic enrollment
- Employees of companies that have eligible automatic enrollment arrangements (EACA) can elect to withdraw the automatic contributions.
- The election must be made within 30-90 days after the first automatic enrollment contributions are deducted.
- Birth or adoption
- Your plan can distribute up to 5,000 dollars for a birth or to help fund an adoption without the penalty.
- Generally, retirement plans would only need the birth certificate or adoption papers to authorize the distribution
- Corrective distributions
- Withdrawals to correct excess contributions and earnings from excess contributions are not subject to the penalty
- Death
- After the plan or account owner passes away, the beneficiaries must generally liquidate the plan assets within 10 years. The liquidating distributions are not subject to early withdrawal additional tax
- Disability
- Plan participants may make early withdrawal, penalty free distributions after they become totally and permanently disabled.
- Someone is considered totally and permanent disabled under the following test:
- You can’t do any gainful activity because of the physical or mental condition, and
- A physician has determined that the condition will either result in death or be of a long, continued, and indefinite duration
- Disaster recovery distribution
- Distributions due to a qualifying disaster (usually in a federally declared disaster area, and in 2020 for COVID-19) have many special accommodations. One of those benefits is that the distribution is not subject to the 10% penalty.
- Domestic abuse victim
- Abuse is defined for this exception as physical, psychological, sexual, emotional, or economic abuse, and includes actions that aim to control, isolate, humiliate, or intimidate the victim, as well as efforts to undermine the victim’s ability to reason independently.
- Victims of domestic abuse may withdrawal the lesser amount between
- $10,000, or
- 50% of the vested balance in the retirement plan
- Domestic relations (QDRO)
- For equitable property splits in divorce, a qualified domestic relations order can give the former spouse a claim to a portion of the retirement plan assets of the other spouse. Usually, a percentage or dollar amount.
- The alternate payee (the spouse that benefits from the QDRO) can make distributions of QDRO funds before they are 59.5 years old without the early withdrawal penalty.
- Higher education expenses
- You can take early withdrawals from your IRA up to the amount of your qualified education expenses.
- The qualified education expenses for this exception have the same rules as for education credits. The student must be:
- You
- Your spouse
- Your child or grandchild.
- Emergency personal expense
- You can take one distribution per calendar year for personal or family emergency expenses at the lesser of $1,000 or the vested account balance over $1,000 (made after 12/31/2023)
- Emergency is defined as follows:
- An unforeseeable or immediate financial need
- Emergency savings account
- Emergency related distributions from pension-linked savings account (made after 12/31/2023)
- Emergency is defined as explained above.
- ESOP dividends
- Distributions of dividends from employer stock held in an employee stock ownership plan
- First time homebuyer
- Qualified first-time homebuyers can take up to $10,000 early withdrawal penalty-free.
- A qualified first-time homebuyer includes anyone who has not owned a home in the last two years.
- IRS levy
- Distributions that were made directly from the retirement plan to the IRS under a levy are penalty-free
- Medical expenses
- Distributions to cover the portion of out-of-pocket medical expenses that exceed the itemized deduction medical expense limit of 7.5% of adjusted gross income.
- For example, your income is $10,000, and you have $1,000 of medical expenses. You could withdrawal $250 to cover the medical expenses without paying an early withdrawal penalty
- Health insurance premiums while unemployed
- Distributions to pay health insurance premiums while unemployed.
- You need to have been unemployed for 12 weeks, and
- You must have received unemployment compensation during the year
- Military duty
- Distributions from qualified retirement plans can be made to members of the military who are called to active duty. The rules are as follows
- Your active duty must be for a period more than 179 days or an indefinite period.
- The distribution is made after the active-duty orders start and before the close of the active duty period.
- Returned IRA contributions
- Like corrective distributions, distributions of returned IRA contributions and earnings on contributions are not subject to the early withdrawal penalty
- Rollovers
- Any rollovers from one eligible retirement plan to another are not subject to the early withdrawal penalty.
- Utilize direct transfers between plans to avoid needing to file Form 5329 to claim the exception.
- Separation from service
- Workers who leave their employment may be able to take retirement plan distributions without penalty if they meet the following requirements:
- You separate from your employer after reaching age 55
- You separate from your employment as a public safety employee. This includes police, firefighters, and EMS employees
- The distribution is made after you left employment, and you left employment during or after the year you reached the age requirements mentioned above.
- Terminal illness
- Distributions made on or after the date your physician has certified you have a terminal illness.
Take time to plan before you take an early distribution from a retirement plan
There are many reasons people decide to take money out of a retirement plan before reaching retirement age. If there seems to be a financial need to make a withdrawal, take some time to see if there are any exceptions to the early withdrawal penalty that may apply to you and make sure you will meet all the requirements to qualify for the exception to the additional tax.
