Know the 15 Exceptions to the 10 Percent Penalty on Early IRA Withdrawals
In a pinch, you may need to take some money out of your traditional IRA(s) before age 59 1/2, which we will call
early withdrawals.
Most traditional IRA withdrawals are at least partially taxable. The taxable portion of withdrawals taken before age 59 1/2 will also be hit with the 10 percent early withdrawal penalty tax unless an exception applies.
For purposes of the exceptions to the 10 percent early withdrawal penalty tax, traditional IRAs include IRAs, SEP-IRAs, and SIMPLE IRAs.
Early withdrawals from a SIMPLE IRA during the first two years of participation incur a 25 percent penalty tax instead of the usual 10 percent penalty.
For simplicity, we will not consider this 25 percent penalty in the rest of this article. But remember this higher penalty rate, because it can be unexpected and costly.
Finally, there can be a 10 percent penalty tax on the non-taxable portion of some early Roth IRA withdrawals, as we will explain later in this article.
The good news is, there are quite a few exceptions to the 10 percent penalty tax for early IRA withdrawals, and we will now cover them. Here it goes.
Exceptions to the Penalty Tax on Early IRA Withdrawals
You can withdraw money from an IRA at any time and for any reason because you, as the account owner, are in total control. But most traditional withdrawals will be at least partially taxable, and the 10 percent penalty tax can hit the taxable portion of withdrawals taken before age 59 1/2.
The current list of exceptions to the 10 percent penalty on early IRA withdrawals goes like this.
Penalty Exception 1. Withdrawals That Count as Substantially Equal Periodic Payments
In many cases, the most practical way for a cash-starved IRA owner to be able to take significant penalty-free early withdrawals is to arrange for substantially equal periodic payments.
The substantially equal periodic payment drill is sometimes called annuitizing the account, because you must receive a series of annual payouts.
If you have several IRAs, you do not need to take substantially equal periodic payments from them all. Instead, you can annuitize one or more accounts to generate annual substantially equal periodic payments that are big enough to meet your cash needs. You can leave your other tax-advantaged retirement accounts untouched.
Substantially Equal Periodic Payment Caveats
Unfortunately, the substantially equal periodic payment exception has two big traps for the unwary.
Trap 1. Once you begin taking substantially equal periodic payments, you must stick with the program for at least five years or until attaining age 59 1/2, whichever comes later. If you stop taking annual substantially equal periodic payments too soon, all the pre-age-59 1/2 withdrawals that you thought were going to be taken under the substantially equal periodic payment exception can be hit with the 10 percent penalty tax.
The same bad thing can happen if you modify the annuitized account during the period when substantially equal periodic payments are required—for example, by making annual contributions to that account, or by rolling over all or part of that account into another account. Be careful!
Trap 2. You must properly calculate annual substantially equal periodic payment amounts. If the correct annual amounts are not withdrawn, it’s deemed to be a prohibited modification of the substantially equal periodic payment drill.
The result of a prohibited modification is that all the pre-age-59 1/2 withdrawals that you thought were going to be taken under the substantially equal periodic payment exception can be hit with the 10 percent penalty tax. So, there can be a big retroactive tax whammy if you fail to take out the right amount each year. Again, be careful!
IRS-Approved Methods for Calculating Substantially Equal Periodic Payments
The three IRS-approved methods for calculating substantially equal periodic payments are as follows:
1. The required minimum distribution (RMD) method
2. The fixed amortization method
3. The fixed annuitization method
Penalty Exception 2. Withdrawals for Medical Expenses in Excess of 7.5 Percentof Adjusted Gross Income (AGI)
You can take advantage of this exception when you have eligible medical expenses in excess of the threshold for itemizable medical expenses, which is 7.5 percent of AGI. IRA withdrawals up to the amount of that excess are exempt from the 10 percent penalty tax.
It doesn’t matter if you itemize or not. But you must pay the medical expenses in the same year that you receive the early withdrawal money.
Penalty Exception 3. Withdrawals for Qualified Higher Education Expenses
You can take early penalty-free IRA withdrawals to the extent of qualified higher education expenses paid during that same year.
Qualified higher education expenses are defined in the same way as tax-free withdrawals from Section 529 plans. But the qualified expenses must be for the education of
you (the account owner) or your spouse, or
your child, stepchild, or adopted child.
You cannot use this exception for expenses that are allocable to certain tax-free educational benefits, such as scholarships.
As stated above, you must pay the qualified higher education expenses in the same year you receive the early IRA withdrawal.
Penalty Exception 4. Withdrawals for Qualified Home Acquisition Costs ($10,000 Lifetime Limit)
Thanks to this exception, you can take penalty-free early IRA withdrawals up to the amount spent by you (the account owner) within 120 days to pay for qualified acquisition costs for an eligible principal residence. There is a lifetime $10,000 limit on this exception.
The principal residence can be acquired by
you (the account owner) or your spouse;
your child, grandchild, or grandparent; or
your spouse’s child, grandchild, or grandparent.
The buyer of the principal residence (and the buyer’s spouse, if the buyer is married) must not have owned a present interest in a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as costs to acquire, construct, or reconstruct a principal residence—including closing costs.
Penalty Exception 5. Withdrawals for Births or Adoptions
You can claim penalty-free treatment for a withdrawal taken before age 59 1/2 for a qualified birth or adoption.
That means a withdrawal taken during the one-year period beginning on the date when an eligible child of you (the account owner) is born or the date when the legal adoption of an eligible adoptee of yours is finalized.
An eligible adoptee means any individual (other than a child of yours or a child of your spouse) who has not attained age 18 or is physically or mentally incapable of self-support.
The maximum penalty-free qualified birth or adoption withdrawal for any eligible birth or adoption is $5,000, and this limit is apparently applied on an individual-by-individual basis. So, when both members of a married couple have IRAs, each spouse can apparently withdraw up to $5,000 penalty-free for a qualified birth or adoption.
Penalty Exception 6. Withdrawals for Emergency Expenses
For early withdrawals taken after December 31, 2023, a new exception applies to so-called emergency personal expense withdrawals, as defined by our beloved Internal Revenue Code. You cannot use this exception more than once a year, and the maximum penalty-free withdrawal is $1,000.
Penalty Exception 7. Withdrawals for Disaster Recovery
You can use this exception to take penalty-free qualified disaster recovery withdrawals, as defined. The aggregate amount that can be treated as qualified disaster recovery withdrawal over the years for any particular qualified disaster is limited to $22,000.
Penalty Exception 8. Withdrawals after Disability
This exception applies to early withdrawals taken by an IRA owner who is determined to be physically or mentally disabled to the extent that the owner cannot engage in his or her customary gainful activity or a comparable gainful activity. In addition, the disability must (1) be expected to lead to death, or (2) be of long or indefinite duration. But the disability need not be expected to be permanent to satisfy the preceding requirement.
In Dwyer, the Tax Court concluded that being eligible for Social Security disability benefits proved disability for purposes of this exception. But in Kowsh, the Tax Court concluded that receiving private disability insurance benefits did not necessarily prove disability for purposes of this exception.
Penalty Exception 9. Withdrawals for Long-Term Care
For early IRA withdrawals taken after December 29, 2025, another new exception will apply to qualified long-termcare distributions, as defined.
Penalty Exception 10. Withdrawals for Terminal Illness
This exception applies to early withdrawals taken by a terminally ill individual, as defined.
Penalty Exception 11. Withdrawals after Death
This exception applies to amounts paid to a deceased IRA owner’s estate or account beneficiary on or after the date of the owner’s death. In other words, this exception means amounts withdrawn from an IRA after the account owner’s death will always be free of the 10 percent penalty tax.
Note that this exception won’t be available for funds rolled over into a surviving spouse’s IRA or if the surviving spouse elects to treat the inherited IRA as his or her own account.
If the surviving spouse needs some of the inherited funds, those funds should be left in the inherited IRA (i.e., the one originally set up by the deceased spouse). Then the surviving spouse can withdraw the needed funds from the inherited IRA without any 10 percent penalty, thanks to this exception.
Penalty Exception 12. Withdrawals by Military Reservists Called to Active Duty
This exception applies to certain early IRA withdrawals taken by military reserve members who are called to active duty for at least 180 days or for an indefinite period.
Penalty Exception 13. Withdrawals for Health Insurance Premiums during Unemployment
This exception is available to an IRA owner who has received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the preceding year.
If this condition is satisfied, the IRA owner’s early withdrawals during the year in question are penalty-free up to the amount paid during that year for health insurance premiums to cover the account owner and his or her spouse and dependents.
But early withdrawals after the owner has regained employment for at least 60 days don’t qualify for this exception.
Penalty Exception 14. Withdrawals for Domestic Abuse Victims
For early withdrawals taken after December 31, 2023, another new exception applies to eligible distributions to domestic abuse victims, as defined—subject to a $10,000 limitation, as adjusted for inflation after 2024.
Penalty Exception 15. Withdrawals for IRS Levies
This exception applies to early IRA withdrawals taken to pay IRS levies against the account.
Note that this exception is unavailable when the IRS levies against the IRA owner (as opposed to the IRA itself)and the owner then withdraws IRA funds to pay the levy.
Remember: You Are Home Free after Reaching Age 59 1/2
After you reach the magic age of 59 1/2, all the exceptions to the 10 percent early withdrawal penalty tax become moot. You can withdraw money at any time and for any reason without having to worry about the 10 percent penalty tax.
Takeaways
Early IRA withdrawals, typically before age 59 1/2, are subject to a 10 percent penalty tax on the taxable portion, with several exceptions to mitigate this penalty. Understanding these exceptions is crucial for those needing accessto funds without incurring hefty penalties.
The 15 exceptions to the 10 percent penalty tax include:
Substantially equal periodic payments. For this exception, penalty-free withdrawals require adherence to specific conditions.
Medical expenses. Withdrawals for medical expenses exceeding 7.5 percent of AGI are exempt.
Higher education expenses. Qualified educational expenses can be covered by penalty-free withdrawals.
First-time home purchase. Withdrawals up to a $10,000 lifetime limit are available for home acquisition costs.
Birth or adoption. Penalty-free withdrawals up to $5,000 are possible for birth or adoption expenses.
Emergency expenses. A new provision allows up to $1,000 annually for emergency expenses.
Disaster recovery. Withdrawals for qualified disaster recovery are exempt up to $22,000.
Disability. Withdrawals due to disability are penalty-free under specific conditions.
Long-term care. Starting in 2025, withdrawals for qualified long-term care are exempt.
Terminal illness. Withdrawals for terminally ill individuals are penalty-free.
Post-death withdrawals. Withdrawals after the account owner’s death are penalty-free.
Military reservists. Active-duty reservists can withdraw penalty-free.
Health insurance premiums during unemployment. Penalty-free withdrawals are possible for health insurance payments during unemployment.
Domestic abuse victims. Penalty-free withdrawals up to $10,000 are available for domestic abuse victims.
IRS levies. Withdrawals to pay IRS levies against the IRA account are exempt from penalties.
Also remember these important considerations:
SIMPLE IRAs have a 25 percent penalty for early withdrawals within the first two years.
Roth IRA withdrawals follow different rules, often allowing penalty-free access to contributions but not earnings.
By leveraging the exceptions, you can access your IRA funds without facing significant penalties, provided your withdrawals adhere to the specific rules and conditions of each exception.
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