The government uses retirement plans, such as 401Ks and IRAs, as an incentive to save money for retirement. The government encourages this by allowing taxed-deferred contributions to eligible retirement plans and IRAs. If the money remains in the account until the account owner is at least 59 years old, regular taxes on the distribution are relatively low.
The government discourages an early retirement withdrawal, however, with the assessment of a 10 percent early distribution tax. Consequently, in addition to paying regular income tax on the withdrawal, a penalty also applies. In some circumstances, an owner may make an early retirement withdrawal from a retirement account or an IRA without a penalty. The following are exceptions to the early distribution tax.
Exceptions to the Early Distribution Tax
Death
Although it is probably the least desirable method of escaping the early distribution tax, the death of the plan's owner is a way to avoid the penalty. The early withdrawal tax does not apply to any of the funds distributed to the beneficiary from an IRA or retirement account. If the beneficiary is a spouse, the spouse may rollover the distribution into their retirement plan or IRA. However, the exception to the distribution tax no longer applies once the funds are in the name of the spouse.
Disability
All distributions from a retirement account are penalty-free when a person becomes disabled. The law defines a 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 to be of long-continued and indefinite duration." Essentially, to qualify under the disability exception, a permanent disability must exist at the time of the distribution. It is irrelevant whether the disability is later determined to be permanent.
Substantially Equal Periodic Payments
Another way to avoid the distribution tax is by taking substantially equal periodic payments, which is available to an owner of any age. The following rules apply to this exception:
Leave or Retire from a Job after 55
A person will not have to pay an early distribution tax on money taken from an employer's retirement plan if they are at least 55 years old when retiring or leaving a job. This exception applies to each employer so it is possible to work for another employer and still qualify for the exception. The following guidelines apply:
Early Retirement Withdrawal for Medical Expenses
Withdrawing money from a retirement plan to pay for medical expenses is penalty-free under certain circumstances. The exception only applies to the portion of the medical expenses that would be deductible if itemized on a tax return. It is unnecessary to itemize deductions to qualify. On a tax return, a person may deduct the amount of medical expenses for themselves, their spouse, and dependents that exceed 7.5 percent of their adjusted gross income. The distribution tax for an early withdrawal for medical expenses also uses the same limit. Â
Early Retirement Withdrawal of Dividends from ESOPs
Employee stock ownership plans, also referred to as ESOPs, is a stock bonus plan that is similar to a purchase pension plan and is funded almost exclusively with the employer's stock. Some plans allow cash distributions if the employee has the option of requesting the payment of benefits in employer stock. Regardless of when an employee receives dividends from the employer's stock, the early distribution tax is inapplicable.
QDRO Payments
If money from a retirement plan is used to pay alimony or child support, the early distribution tax is inapplicable if a Qualified Domestic Relations Order (QDRO) is in place. A QDRO is a court-ordered property agreement used in divorces or separation agreements that gives an "alternative payee," such as a spouse, a former spouse, or a dependent child, the right to receive distributions from the retirement plan. Â
Refunds
Refunds for contributions that exceed legal contribution limits of a retirement plan are penalty-free when the plan administrator makes a "corrective" distribution. To qualify, the distribution must occur before the owner submits a tax return to the IRS. Other taxes and penalties may apply to the distribution.
Special Exceptions for Traditional IRAs
A few variations apply to traditional IRAs. The age exception and the exception for a QDRO for child support or alimony do not apply to IRA accounts. However, IRA plans do allow owners to make early withdrawals without penalty in the following situations:
Health Insurance Premiums
If an early distribution is used to pay a health insurance premium when the owner is unemployed or during the time of the owner's recent unemployment, the IRA funds used to pay the premium are not subject to the early distribution tax if the following conditions are satisfied:
A self-employed person may also qualify for a penalty-free distribution if all of the requirements for unemployment benefits would have been satisfied if the person had not been self-employed.
Educational Expenses
A distribution to pay for higher education expenses is not subject to a penalty when the following conditions are satisfied:
First-Time Home Buyer
First-time homebuyers may make an early withdrawal without a penalty under the following circumstances:
Refund
If an IRA owner contributes more than is legally allowed, a withdrawal of the excess is penalty-free if taken prior to filing a tax return. The income earned on the excess, however, is subject to the early distribution tax once it is withdrawn.
