It’s one thing to be taxed on retirement contributions and their related earnings when you withdraw funds from your IRA or 401(k) during retirement. It’s quite another when you pay the tax plus a 10% penalty for an early withdrawal. Need funds prior to retirement and want to avoid the early withdrawal penalty? Here is what you need to know.

Retirement plan basics

Generally, if you participate in a tax-beneficial retirement plan, you cannot withdraw funds until you reach the age of 59 1/2. If you do, you are not only subject to income taxes but also to an additional 10% early withdrawal penalty.

Covered plans: Qualified plans like 401(k)s, 403(b)s, and 457s. Plus IRAs, SEPs, SIMPLE IRAs, and SARSEP plans.

The penalty: 10% early withdrawal penalty. 25% with SIMPLE plans when funds are withdrawn within 24 months of opening the account.

Roth accounts: The early withdrawal penalty applies to Roth IRAs if funds are withdrawn before age 59 1/2 or within 5 years of the contribution. The penalty ONLY applies to earnings, as your contributions in this account were already taxed.

The early withdrawal penalty

The early withdrawal penalty can be avoided before reaching age 59 1/2. Here are the common ways to do so:

1. Substantially equal payments. If you make equal payments for at least 5 years or until you reach age 59 1/2, using IRS-approved calculations, AND are not employed by the employer sponsoring the plan, you can avoid the penalties.
2. Birth or adoption. Up to $5,000 per child can be withdrawn.
3. Death/disability/terminally ill. There is still compassion here.
4. Disaster recovery distributions. Up to $22,000 if in a federally declared disaster recovery area.
5. Victim of domestic abuse (spouse or domestic partner). Up to $10,000 or 50% of the account value, whichever is less.
6. Medical expenses. If you need to withdraw from your IRA to fund medical expenses in excess of 7.5% of your Adjusted Gross Income, you may do so penalty-free.
7. You’re the beneficiary. If you are the beneficiary of someone else’s IRA and they die, there is usually an opportunity to withdraw funds without the penalty. Plenty of caution is required in this scenario because if treated incorrectly, the penalty might apply.
8. Conversions of traditional IRAs to Roth IRAs. Want to convert your traditional IRA into a Roth IRA to avoid paying taxes on future account earnings? No problem. This is also considered a qualified event to avoid the 10% penalty.

To complicate matters, the following are examples of penalty-free withdrawals from IRAs, but they are not available to qualified plans such as 401(k)s.

1. Medical insurance premiums if unemployed. If you receive federal or state unemployment for 12 or more consecutive weeks, you may pay for medical insurance premiums from your Traditional IRA without paying the 10% early withdrawal penalty. The premiums may cover yourself, your spouse, and your dependents’ medical insurance premiums.
2. Paying for education. You may pay for tuition, books, fees, supplies, and equipment at a qualified post-secondary institution for yourself, your spouse, your child, or grandchild from your Traditional IRA without paying the 10% penalty.
3. First-time homebuyer expenses. IRA distributions of up to $10,000 to help pay the qualified acquisition costs of a first-time home buyer and avoid the early withdrawal penalty. This is a lifetime limit per individual. A first-time homebuyer is defined by the IRS as not having an ownership interest in a principal residence for two years prior to the new home acquisition date. Even better, to qualify, the home can be for you, your spouse, your child, your grandchild, your parent, or another ancestor.

Key takeaways

• Remember, the above ideas help you avoid an early withdrawal penalty on funds withdrawn from your IRA or 401(k) before age 59½. After this age, there is no early-withdrawal penalty. The penalty is also waived if you become permanently or totally disabled or use the funds to pay an IRS tax levy.
• While the above events allow you to avoid the 10% early withdrawal penalty, you will still need to pay the income tax due on the withdrawn funds.
• The IRS has a nice chart that outlines these exceptions. It is noted here for your use.

Before taking any action, contact our RRBB advisors to have your situation reviewed. It’s almost always better to keep funding your IRA or 401(k) until you retire.