Exceptions To The Early Withdrawal Penalty From Your Retirement Fund

Telling Tips is a series of articles from local experts to help you save money, make better decisions and plan for a better future.

Some of you may need to take a withdrawal from your retirement account to make ends meet. Before doing so, I would suggest almost any other avenue — credit card advance, family, sale of unneeded assets. However, the first thing you should do is to call your tax preparer and work through a budget. If all else fails, a withdrawal may be the only way to live. Remember, this withdrawal may cost you up to 40 percent of the amount withdrawn: Federal 10 percent penalty, Federal tax rate of 20 percent and State and local tax rate of 10 percent.

There are some exceptions to the 10 percent penalty.

Exceptions for Early Distributions from an IRA:

1) Rollover:

a. You had a “direct rollover” to your new retirement account, or

b. You received a lump-sum payment but rolled over the money to a qualified retirement account within 60 days,

2) Disability: You were permanently or totally disabled *

3) Medical Insurance: You were unemployed and paid for health insurance premiums.

If you used the IRA withdrawal to pay medical insurance for yourself, your spouse, and your dependents, the penalty is not imposed if ALL of the following conditions are met:

• You lost your job, AND
• You received unemployment compensation under any federal or state law for 12 consecutive weeks because you lost your job, AND
• You receive the distributions during either the year you received the unemployment compensation or the following year, AND
• You receive the distributions no later than 60 days after you have been reemployed.

4) Higher education expenses: The penalty is avoided if you paid for higher education during the year for you, your spouse, your children, or grandchildren at an eligible educational institution.

Note that ‘Qualified Higher Education Expenses’ include tuition, fees, books, supplies, and required equipment. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board is qualified higher education expenses.

An ‘Eligible Educational Institution’ includes any college, university, vocational school, or other post-secondary educational institution eligible to participate in the student aid programs administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) post-secondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

5) First Home: You buy, build, or rebuild a house, AND

• You did not own a home in the previous two years, AND
• Only $10,000 of the withdrawal qualified for the penalty exception.

Loophole: If you have not used this distribution yourself, you may take the distribution for your children, grandchildren, or even your parents!

Loophole: This applies separately to you and your spouse. Therefore, up to $20,000 can be withdrawn, penalty free. (Of course you still have the pay the tax, silly.)

6) Unreimbursed Medical: You paid for medical expenses exceeding 7.5 percent of your adjusted gross income**

7) IRS Levy: The IRS levied your retirement account to pay off tax debts.

8) Beneficiary: If you die before reaching age 59-and-a-half, the assets in your traditional IRA can be distributed to your beneficiary or to your estate without either having to pay the 10 percent additional tax.

However, if you inherit a traditional IRA from your deceased spouse and elect to treat it as your own, any distribution you later receive before you reach age 59-and-a-half may be subject to the 10 percent additional tax.

9) Annuity: Taking your IRA as an annuity instead of in a lump sum. ***

10) Qualified Reservist: A qualified reservist distribution is not subject to the additional tax on early distributions

IRA Notes

a. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.  Be aware that all distributions for an account that contains both deductible and nondeductible contributions is distributed ratably based between the deductible and nondeductible balances in the account.

b. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.

Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan

1. Disability: Distributions upon the death or disability of the plan participant. *

2. Age: You were age 55 or over and you retired or left your job.

3. Annuity: You received the distribution as part of “substantially equal payments” over your lifetime. ***

4. Unreimbursed Medical: You paid for medical expenses exceeding 7.5 percent of your adjusted gross income. **

5. Divorce: The distributions were required by a divorce decree or separation agreement. (“qualified domestic relations court order”)

* If you become disabled before you reach age 59-and-a-half, any distributions from your traditional IRA because of your disability are not subject to the 10 percent additional tax.

You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration

** This calculation is:

a) The amount you paid for unreimbursed medical expenses during the year,

b) Minus 7.5 percent of your adjusted gross income for the year of the distribution.

You can only take into account unreimbursed medical expenses that you would be able to include in figuring a deduction

on Schedule ‘A’, Form 1040.

Loophole: You do not have to itemize your deductions to take advantage of this exception to the 10 percent additional tax.

*** You can avoid the penalty by taking your IRA as an annuity instead of in a lump sum. Or stated another way:

a) They have to be substantially equal payments,

b) Over your life (or your life expectancy), or over the lives (or the joint life expectancies) of you and your beneficiary.

If you are under 59-and-a-half, retired, and just waiting for this magical age, this exception may be just the thing. You could take your 401(k), roll it into the IRA, and start taking distributions — now. You can travel, pursue a hobby, start a business, or whatever. (Before doing so, make sure you speak with your tax preparer.)

Closing Notes

Most payers will withhold federal taxes at a rate of 10 or 20 percent, but will not withhold any state or local taxes.

If you are withdrawing from your pension, you will need to make an estimated tax payment. Call the office to discuss this even before your withdrawal.

(Remember: Psychiatrists say a man shouldn’t keep too much to himself. So does the IRS.)

Have a good week.

Joseph Reisman, of Joseph S. Reisman & Associates, has been serving tax prep and business accounting expertise from his Coney Island Avenue office for more than 25 years. Check out the firm’s website.