It happens to the best of us – I understand. You lost your job, your kid needs his ACL replaced because of the skateboard ramp that you yourself built in the driveway, your wife needs a new diamond. I’d like to tell you to go ahead and tap into that IRA without thinking about taxes but that’s not a reality!
The fact is that section 72(t)–which governs the tax exemption on retirement account funds, and the potential waiver of the 10% penalty that is standard for non-qualified early distributions of them–is a tricky area of tax law, and especially if you’re in distress, you’ll want to get it right. Additionally, the same circumstances are treated differently for different types of retirement accounts – a variable which can be strategically used to your advantage, or present more pitfalls if misunderstood.
If you’re about to pick up the phone and call me with a bunch of questions, I thought I’d try to save you some time by trying to answer a few of them first. And I will start by saying that you should never make an early withdrawal unless it’s absolutely necessary (and that I don’t actually think that includes the new diamond – but I’m sure I don’t know the whole story).
There are some circumstances where an early withdrawal (might) make sense:
New home purchase
If neither you or your spouse has owned another home for the last two years, up to $10,000 can be withdrawn early from an IRA for the purchase of a new home. The funds will be still be taxed as ordinary income, but the 10% fee will be waived as long as you make the home purchase or sign a construction contract within 120 days of the withdrawal. There is no waiver for qualified plans – so any withdrawal for a home purchase from a qualified plan will be subject to ordinary income tax as well as a 10% penalty.
Early withdrawals from both IRAs and qualified plans are penalty free when used for immediate medical expenses for the taxpayer, spouse, and dependents – but are still subject to income tax. However this exception only applies to medical expenses that have not been reimbursed and exceed 10% of the taxpayer’s adjust gross income. If the taxpayer is unemployed, early withdrawals from an IRA (but not a qualified plan) can also be used to pay medical premiums penalty-free (but not tax-free).
Early distributions from an IRA for higher education costs are exempt from the 10% penalty, but are still subject to income tax; while with qualified plans there is no exemption. For that reason, if you are planning to use retirement funds for higher education costs, it might make sense to roll over money from your qualified plan into an IRA before withdrawing funds for education – in this way the penalty can be avoided. If you withdraw directly from the qualified plan, the penalty applies – and a transfer can not be retroactively made to qualify for the waiver.
Early IRA distributions must be paid for education in the same year that they are withdrawn, and may also qualify (penalty but not tax-free) for use towards room and board if the student is enrolled at least half time. Any such expenses are first reduced by any grants or scholarships that the student receives tax-free. And these funds cannot be used toward any other tax benefits for the student, such as the Lifetime Learning credit, or the American Opportunity Tax Credit.
There are some circumstances where retirement funds can be withdrawn early for general living expenses before the age of 59½. For qualified plans but not IRAs, if you retire or quit your job when you’re 55 or older (50 or older for public safety workers) you can withdraw your funds without the 10% penalty. Before the age of 55, there is also a way can get your money from either an IRA or or qualified plan – being terminated from employment. In this case the penalty is waived but the money is still taxed as regular income. To do this, a taxpayer must accept what is called SEPP: a series of Substantial Equal Periodic Payments. Once started, these payments must be continued for at least five years or until the taxpayer is 59½, whichever is longer, or a penalty is imposed.
Other scenarios that allow for early penalty-free distribution include divorce, when funds are divided from a qualified plan with a QDRO – Qualified Domestic Relations Order. Permanent disability and death also qualify for penalty-free early withdrawals from both qualified plans and IRAs.
Generally speaking, the best thing to do with funds in your IRA or qualified retirement plan, is to leave them there to do their thing. Money in these accounts is allowed to grow with protection from not just taxes, but also things like creditors in the event of bankruptcy. And the tax laws governing early distributions are so complex, that even the most savvy CPAs can make mistakes – so if you must, give me a call first!