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Tax Guy: What is the penalty for an early IRA withdrawal — and what are the 10 exceptions that let you take cash out early penalty-free?


All the free money from the government has been spent, and inflation is raging. Now you’re facing a vicious cash shortfall. What to do?

One possible solution is taking an early withdrawal from your IRA. By early withdrawal, I mean one that occurs before age 59½. Needless to say, there are federal income tax implications, including the possibility of getting socked with the dreaded 10% early withdrawal penalty tax. Here’s what you need to know to make a well-informed decision.   

Early withdrawals from an IRA are usually taxable, but a penalty tax can often be avoided  

In almost all cases, all or part of any withdrawal from a traditional IRA will count as taxable gross income. The taxable percentage depends on whether you’ve made any nondeductible contributions to the account. 

If you have, each withdrawal consists of a proportionate amount of your total nondeductible contributions, and that part is tax-free. 

The proportionate part of each withdrawal that consists of deductible contributions and accumulated earnings is taxable. If you’ve never made any nondeductible contributions, 100% of any withdrawal is taxable.  

While it might be impossible to avoid triggering taxable income by taking a withdrawal before age 59½, you might be able to avoid the 10% penalty tax on early withdrawals by taking advantage of the exceptions explained below. Please read on.

The penalty tax exceptions for early withdrawals from traditional IRAs 

The following exceptions to the 10% federal penalty tax are available for early withdrawals (before age 59½) from traditional IRAs, which for this purpose include simplified employee pension (SEP-IRA) accounts and SIMPLE-IRA accounts. 

1. Substantially equal periodic payments (SEPPs) 

These are annual annuity-like withdrawals that must be taken for at least five years or until the you reach age 59½, whichever comes later. The rules for SEPPs are complicated. You may want to get your tax advisor involved to avoid pitfalls.  

2. Withdrawals for medical expenses 

If you have qualified medical expenses in excess of 7.5% of adjusted gross income (AGI), early IRA withdrawals up to the amount of the excess are exempt from the 10% penalty tax. However, the medical costs must be paid in the same year you take the early withdrawal. 

3. Withdrawals for qualified higher education expenses 

Early IRA withdrawals are penalty-free to the extent of qualified higher education expenses paid during the same year. The qualified expenses must be for the education of: (1) the account owner or the account owner’s spouse or (2) a child, stepchild, or adopted child of the account owner or the account owner’s spouse. 

4. Withdrawals to pay health insurance premiums during unemployment 

This exception is available to an IRA owner who has received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the preceding year. If this condition is satisfied, the IRA owner’s early withdrawals during the year in question are penalty-free up to the amount paid during that year for health insurance premiums to cover the account owner, spouse, and dependents. However, early withdrawals after the account owner has regained employment for at least 60 days don’t qualify for this exception.  

5. Withdrawals for births or adoptions 

Penalty-free treatment for a qualified birth or adoption distribution (withdrawal). That means a distribution made during the one-year period beginning on the date when an eligible child of the account owner is born or the date when the legal adoption of an eligible adoptee of the account owner is finalized. An eligible adoptee means any individual (other than a child of the account owner’s spouse) who has not attained age 18 or is physically or mentally incapable of self-support. The maximum penalty-free qualified birth or adoption distribution for any eligible birth or adoption is $5,000, and this limit is apparently applied on an individual-by-individual basis. So, when both members of a married couple have eligible retirement accounts, each spouse can apparently receive a $5,000 penalty-free qualified birth or adoption distribution. 

6. Withdrawals for first-time home purchases ($10,000 lifetime limit) 

This exception allows penalty-free IRA withdrawals to the extent of money spent by the account owner within 120 days to pay for qualified acquisition costs for a principal residence. However, there is a lifetime $10,000 limit on this exception. The principal residence can be acquired by: (1) the account owner or the account owner’s spouse; (2) the account owner’s child, grandchild, or grandparent; or (3) the spouse’s child, grandchild, or grandparent. The buyer of the principal residence (and the spouse if the buyer is married) must not have owned a present interest in a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as costs to acquire, construct, or reconstruct a principal residence — including closing costs. 

7. Withdrawals by military reservists called to active duty 

This exception applies to certain early IRA withdrawals taken by military reserve members who are called to active duty for at least 180 days or for an indefinite period.  

8. Withdrawals after disability 

This exception applies to amounts paid to an IRA owner who is found to be physically or mentally disabled to the extent that he or she cannot engage in his or her customary gainful activity or a comparable gainful activity. In addition, the disability must be expected to: (1) lead to death or (2) be of long or indefinite duration. However, the disability need not be expected to be permanent to satisfy the preceding requirement.

9. Withdrawals to satisfy IRS levies 

This exception applies to early IRA withdrawals taken to pay IRS levies against the account. However, this exception is unavailable when the IRS levies against the IRA owner (as opposed to the IRA itself), and the owner then withdraws IRA funds to pay the levy. 

10. Withdrawals after death 

Amounts withdrawn from an IRA after the account owner’s death are always free of the 10% penalty tax. However, this exception is not available for funds rolled over into a surviving spouse’s IRA or if the surviving spouse elects to treat the inherited IRA as his or her own account. If the surviving spouse needs some of the inherited funds, they should be left in the inherited IRA (i.e., the one still treated as having been set up for the deceased spouse). Then the surviving spouse can withdraw the needed funds from the inherited IRA without any 10% penalty tax, thanks to this exception.

What about an early Roth IRA withdrawal?

The immediate tax results will probably be better for an early Roth IRA withdrawal (before age 59½) than for an early traditional IRA withdrawal. That’s because you won’t owe any federal income tax on early withdrawals that consist of annual Roth IRA contributions or contributions from converting a traditional IRA into Roth status. These federal-income-tax free dollars are deemed to come out of the account first.   

Under a weird-but-true rule, you could owe a 10% early withdrawal penalty tax, but no federal income tax, on withdrawals that consist of conversion contribution dollars. But you’ll only owe the penalty tax if the withdrawal occurs within five years of the conversion contribution. And all the exceptions to the 10% penalty tax explained in the context of early withdrawals from traditional IRAs apply equally here.  

After you’ve withdrawn all the annual contribution and conversion contribution dollars, what’s left in your Roth account consists of account earnings. Withdrawals of account earnings are fully taxable unless you’ve had at least one Roth account open for more than five years and are age 59½ or older.

For full details on how Roth withdrawals are taxed, see this previous Tax Guy column

The bottom line: early withdrawals from an IRA should be a last resort       

As explained, most or all of an early traditional IRA withdrawal will probably be taxable. And the withdrawal could push you into a higher marginal federal income tax bracket. You’ll probably also owe the 10% early withdrawal penalty tax, and maybe state income tax too. And, the only way to replace money taken out of your traditional IRA is by making future contributions to refill the tank. That could take many years. In the meantime, you have less money to invest on a tax-deferred basis. 

The immediate tax consequences of taking early Roth IRA withdrawals are usually less harsh. But, once again, it could take years of future contributions to get back to square one, and the end result will be less federal-income-tax-free money available when you reach retirement age. 

For all these reasons, taking an early IRA withdrawal to solve a cash crisis should be a last resort. Unfortunately, sometimes that’s the only option.  

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