As a general rule, if you take an early distribution from a qualified retirement plan or deferred annuity contract before age 59½, you will be hit with dual penalties. First, you will have to pay ordinary income taxes on your withdrawal. Second, you will face a 10 percent penalty on the amount because of the early withdrawal. Those two rules apply to 401(k)s and traditional IRAs. With a Roth IRA, “qualified distributions” escape taxes and penalties, but “nonqualified distributions” do not. The distinctions between the two are complicated, so be sure to consult your CPA for more information. In all cases, the taxation and penalty don’t apply to distributions that are rolled over into another qualified retirement plan.
How Do Exceptions Work?
There are several withdrawal exceptions that are not subject to the penalties. Retirement plans may permit withdrawals when there is an “immediate and heavy” financial need. The IRS notes that the needs that fit this definition vary and are based on each situation. It is safe to say there would be no exception if you have other resources to address the need. The need may relate to yourself, your spouse, or a dependent. In its guidance, the IRS includes funeral or medical expenses in this definition.
Education and Health Exceptions
There are exceptions related to education and health concerns. The penalty generally doesn’t apply (although the tax may) for withdrawals made to cover qualified higher education expenses for yourself, your spouse, or your children or grandchildren. When it comes to health concerns, you may take early withdrawals if you are totally or permanently disabled. In addition, you can tap into your retirement funds to cover medical expenses that add up to more than 7.5 percent of your adjusted gross income. Only deductible medical expenses paid in the year the distribution is taken qualify for the exception.
Medical Insurance for the Unemployed
You can take a penalty-free early distribution for health insurance premiums if you are unemployed, have received unemployment compensation for at least 12 consecutive weeks, and have taken the distributions during the same year in which the unemployment compensation is made, or the succeeding year. These payments are limited to the actual amount paid for insurance. Taxpayers who are self-employed qualify for this exception if self-employment is the only reason they do not qualify for unemployment compensation.
Purchase of a Principal Residence
Qualified first-time homebuyers can take a distribution and escape the 10 percent penalty to the extent that the distribution is used to pay for qualified acquisition costs for a principal residence. Distributions can be up to $10,000 during the individual’s lifetime, provided they are used within 120 days of withdrawal to buy, build, or rebuild a first home that is the principal residence of the individual, his or her spouse or any child, grandchild, or ancestor of the individual or spouse.
Taking Periodic Payments
Another exception comes into play in certain circumstances when you take distributions in a series of substantially equal periodic payments over your own life expectancy or the life expectancies of yourself and your designated beneficiary. These withdrawals must be taken at least annually, and there are complicated approaches to calculating them and ensuring that they remain tax free. Be sure to contact a CPA if you want more information.
There are no penalties if you withdraw funds under a qualified domestic relations order in a divorce case or if you use them to satisfy an IRS levy. Money paid to your beneficiary or your estate also escapes the penalty. Military reservists who have been called to active duty for at least 180 days can also withdraw from their retirement accounts without facing a penalty.
Consult Your CPA
As a general rule, if you need money in a pinch, it’s best to first draw from an emergency fund or from investments that you have. If you don’t have a nest egg available and are seriously considering withdrawing from a retirement account be sure to turn to your local CPA. He or she can provide advice on all your financial questions. To find a CPA in Pennsylvania by location or area of expertise, visit www.IneedaCPA.org.
The CommonWealth Tips columns are a joint effort of the AICPA and the Pennsylvania Institute of Certified Public Accountants (PICPA), as part of the profession’s nationwide 360 Degrees of Financial Literacy program.
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