There are certain life events in which it may be advisable to take an early IRA distribution.
Typically, the IRS requires IRA owners to reach age 59.5 before withdrawing funds from such accounts. They will penalize early distributions with a 10% tax, as well as ordinary income taxes. Seems unfair, but the federal government can and will impose such penalties.
Before contacting your elected government representative with outrage, please remember no taxes have been paid on these retirement savings. IRAs are tax-deferred or legal tax shelters. Meaning, funds are set aside and not taxed until distributions are made later in life (usually after age 59.5). Retirement accounts were set up with long term financial wellness as the goal and folks shouldn’t be frivolously spending these monies before retirement age. Hence, the stiff penalties.
However, taxpayers can escape the early 10% penalty if one of the following exceptions (listed below) can be met. Although ordinary income taxes must still be paid, the IRA could assist when money is needed for a major life event. It is important to note, the following rules apply to traditional IRAs. Plans such as a 401k, SEP IRA, and 403b among others, have rules that may vary from the list below. Keep in mind, this list is not be substituted for sound tax advice, rather suggestions to consider if one finds his/herself in a situation in which money is needed.
- Death or disability – No IRA funds distributed after death will incur a 10% penalty. The law defines disability as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or long term duration. The key to disability lies in the permanence of the condition, not the severity.
- Major medical expenses – this exemption only applies to those medical expenses in excess of 10% of adjusted gross income.
- First time home purchase – the buyer may use up to $10,000 (once per lifetime) towards acquisition, construction, or re-construction of a home. The home buyer must have had no interest in a principal residence during the preceding 2-year period. Also, the first time buyer must be the IRA owner, the owner’s spouse, or child, grandchild, or great-grandchild of the IRA owner. Funds must be used with 120 days of receipt.
- Unemployed and use funds to pay for health insurance – the participant must have received unemployment compensation for 12 consecutive weeks, received funds during the year in which unemployment compensation was received, and the distribution is received no more than 60 days after returning to work.
- Payment of higher education expenses – provided they are used for tuition, books, fees, and supplies. Additionally, they may pay for room and board provided the student is enrolled at least half time. Expenses must be reduced by any tax free scholarships or assistance.
Once again, these rules are not necessarily all-inclusive for every retirement plan. An individual should consult with a licensed tax professional before taking any early IRA distributions and definitely check rules with the plan administrator.