Withdrawing taxable funds from a tax-deferred retirement account before age 59½ generally triggers a 10% federal income tax penalty, on top of any federal income taxes due. [Distributions from Section 457(b) plans are generally not subject to an early distribution penalty; and the penalty for distributions from SIMPLE IRA plans during your first two years of participation is 25%, 10% thereafter.] However, there are certain situations in which you are allowed to make early withdrawals from a retirement account and avoid the tax penalty. (Check your specific plan provisions to see whether a particular withdrawal option is available.)
IRAs and employer-sponsored retirement plans have different exceptions, although the rules are similar.
IRA exceptions
The following distributions are not subject to the 10% penalty tax:
- Death of the IRA owner. Distributions to your designated beneficiaries after your death. Most non-spouse beneficiaries must liquidate the inherited accounts within 10 years.
- Distributions made due to your qualifying disability.
- Unreimbursed medical expenses. Distributions equal to the amount of your unreimbursed medical expenses that exceed 7.5% of your adjusted gross income in a calendar year. (You don’t have to itemize deductions to use this exception, and the distributions don’t have to actually be used to pay those medical expenses.)
- Medical insurance. Distributions made to pay for health insurance if you’ve lost your job and are receiving unemployment benefits.
- Substantially equal periodic payments (SEPPs). Distributions you receive as a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary. You must withdraw funds at least annually based on one of three rather complicated IRS-approved distribution methods. You generally can’t change or alter the payments for five years or until you reach age 59½, whichever occurs later. If you do you’ll again wind up having to pay the 10% penalty tax on the taxable portion of all your pre-59½ SEPP distributions (unless another exception applies).
- Qualified higher-education expenses for you and/or your dependents.
- First home purchase, up to $10,000 (lifetime limit).
- Qualified reservist distributions. Certain distributions to qualified military reservists called to active duty.
- Birth or adoption of a child. Account owners can withdraw up to $5,000 for a qualified birth or adoption of a child. When permitted, distributions can be recontributed within three years.
- Disaster relief. Distributions up to $22,000 for expenses related to a federally declared disaster; distributions are considered gross income over three years (effective for disasters on or after January 26, 2021). When permitted, distributions can be recontributed within three years.
- Terminal illness. Distributions made when you have a terminal illness or condition that may reasonably result in death within 84 months of the date of certification by a physician. When permitted, distributions can be recontributed within three years.
Employer-sponsored plan exceptions
The following distributions are not subject to the 10% penalty tax:
- Death of the plan participant. Upon your death, your designated beneficiaries may begin taking distributions from your account. Most non-spouse beneficiaries must liquidate the inherited accounts within 10 years.
- Distributions made due to your qualifying disability.
- Part of a SEPP program (see above). Distributions you receive as a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary. You generally cannot modify the payments for a period of five years or until you reach age 59½, whichever is longer.
- Attainment of age 55. Distributions made to you upon separation of service from your employer. The separation must have occurred during or after the calendar year in which you reached the age of 55 (age 50 for qualified public safety employees).
- Qualified Domestic Relations Order (QDRO). Payments made to an alternate payee under a QDRO.
- Medical care (see above). Distributions equal to the amount of your unreimbursed medical expenses that exceed 7.5% of your adjusted gross income in a calendar year.
- To reduce excess contributions/deferrals. Distributions made to correct excess contributions you or your employer made to the plan over the allowable limits.
- Qualified reservist distributions. Certain distributions to qualified military reservists called to active duty.
- Birth or adoption of a child. Account owners can withdraw up to $5,000 for a qualified birth or adoption of a child. When permitted, distributions can be recontributed within three years.
- Disaster relief. Distributions up to $22,000 for expenses related to a federally declared disaster; distributions are considered gross income over three years (effective for disasters on or after January 26, 2021). When permitted, distributions can be recontributed within three years.
- Terminal illness. Distributions made when you have a terminal illness or condition that may reasonably result in death within 84 months of the date of certification by a physician. When permitted, distributions can be recontributed within three years.
If you plan to withdraw funds from a tax-deferred account, make sure to carefully examine the rules on exemptions for early withdrawals. For more information on situations that are exempt from the early-withdrawal income tax penalty, visit the IRS website at www.irs.gov.
- Withdrawing from a tax-deferred retirement account before age 59½ generally triggers a 10% federal penalty on top of ordinary income taxes… but there are specific exceptions that allow penalty-free early withdrawals.
- IRA exceptions include death, disability, unreimbursed medical expenses exceeding 7.5% of AGI, health insurance while unemployed, substantially equal periodic payments (SEPPs), qualified education expenses, a first home purchase (up to $10,000 lifetime), qualified reservist distributions, birth or adoption of a child (up to $5,000), federally declared disaster relief (up to $22,000), and terminal illness.
- Employer-sponsored plan exceptions are similar but include some differences: separation from service at age 55 or older (age 50 for qualified public safety employees), Qualified Domestic Relations Orders (QDROs), and corrections of excess contributions.
- SIMPLE IRA plans carry a 25% early withdrawal penalty during your first two years of participation, dropping to 10% after that. Section 457(b) plans are generally not subject to the early withdrawal penalty.
- SEPP (substantially equal periodic payments) distributions must follow one of three IRS-approved methods and generally cannot be modified for five years or until age 59½, whichever is later. Modifying early triggers back-penalty on all prior SEPP distributions.
- Always check your specific plan provisions before assuming an exception applies. Not every plan offers every withdrawal option.
Frequently Asked Questions
What is the 10% early withdrawal penalty?
If you withdraw taxable funds from a tax-deferred retirement account… such as a traditional IRA or 401(k)… before age 59½, the IRS generally imposes a 10% federal penalty on top of any ordinary income taxes owed. This penalty is designed to discourage tapping retirement savings early. However, the IRS recognizes certain hardship and life circumstances that qualify for an exception.
What are the most common IRA early withdrawal exceptions?
The most common penalty-free IRA withdrawal exceptions include death or disability, unreimbursed medical expenses above 7.5% of your AGI, health insurance premiums while receiving unemployment benefits, qualified higher-education expenses, a first home purchase (up to $10,000 lifetime), birth or adoption of a child (up to $5,000), federally declared disaster relief (up to $22,000), terminal illness, qualified reservist distributions, and substantially equal periodic payments (SEPPs).
Are the exceptions different for 401k and other employer-sponsored plans?
Yes, with some overlap. Employer-sponsored plans share several IRA exceptions… including death, disability, SEPPs, medical expenses, reservist distributions, birth or adoption, disaster relief, and terminal illness. But they also include exceptions unique to workplace plans: separation from service at age 55 or older (age 50 for qualified public safety employees), Qualified Domestic Relations Orders (QDROs) from a divorce settlement, and corrections of excess contributions.
What are substantially equal periodic payments (SEPPs)?
SEPPs are a series of distributions calculated using one of three IRS-approved methods and taken at least annually over your life expectancy (or the joint life expectancy of you and your beneficiary). If you follow the rules, SEPP withdrawals are exempt from the 10% penalty regardless of your age. The catch: you generally cannot change or stop the payments for five years or until you reach age 59½, whichever comes later. Modifying payments early triggers the penalty retroactively on all prior SEPP distributions.
Do SIMPLE IRAs and 457(b) plans follow the same rules?
Not exactly. SIMPLE IRA plans impose a 25% early withdrawal penalty during your first two years of participation, which then drops to 10% after that… higher than the standard rate. Section 457(b) plans, which are typically available to state and local government employees, are generally not subject to the early withdrawal penalty at all, regardless of age. Always verify the specific rules that apply to your plan before making a withdrawal.
Sources: Broadridge Investment Management Solutions
Stone Oak Wealth is regulated by the SEC as a registered investment adviser. Please see visit Legal Disclosures for additional advertising disclosures.