When Does the 10% Early Withdrawal Penalty Kick In?
The 10% penalty generally applies to all withdrawals done before age 59 1/2 in traditional IRAs, SEP, and SIMPLE IRAs.
In addition, early withdrawals of earnings may also cause a 10% penalty and be subject to regular income tax if you've had your Roth IRA for less than five years.
Why the Early Withdrawal Penalty Exists
The 10% early withdrawal penalty exists to discourage savers from draining their earnings.
Also, it limits the number of retirees dependent on government assistance. The penalty could help millions from putting at risk their golden years since most American families do not have enough savings for retirement.
Social security benefits give one source of income in retirement. However, those payments seldom cover all of a retiree's expenses.
The early withdrawal penalty can assist workers in saving enough to cover any gap between basic living expenses and social security benefits.
How to Make Penalty-Free IRA Withdrawals
The IRS permits penalty-free IRA withdrawals in some scenarios, including:
Unreimbursed Medical Bills
You may be allowed to take penalty-free distributions from your IRA to cover health insurance or out-of-pocket medical expenses if you do not have any.
When you withdraw from your IRA, you must pay the medical expenses during the same calendar year to qualify.
Your unreimbursed medical bills must exceed 10% of your djusted gross income (AGI) for 2021 onwards.
Disabilities
If you have a disability, especially a total or permanent one, you can dip into your retirement plans without paying a 10% penalty.
Death
Beneficiaries can withdraw from the account without paying the 10% penalty when an IRA account holder dies.
However, spouses who inherit an IRA and select to consider it as their own have restrictions that the IRS imposed.
Thus, spouses taking distributions before age 59 1/2 may be subject to a penalty.
Health Insurance Premiums
If you are unemployed, you may be allowed to take penalty-free withdrawals from your IRA to cover your health insurance premiums.
You must receive unemployment compensation for at least 12 consecutive weeks and withdraw within 60 days after receiving the unemployment compensation.
First-Time Homebuyers
First-time homebuyers are subject to penalty-free withdrawal, provided they have not owned a home in the past two years.
Additionally, when you buy a home, you can take more than one penalty-free withdrawal, but there is a limit of $10,000.
Unpaid Taxes
If you have unpaid taxes, the IRS may let you take a penalty-free withdrawal from your IRA to cover the amount you owe.
Higher Education Expenses
Qualified higher-education expenses are another way to avoid paying the penalty on early withdrawals from an IRA.
These include tuition and related fees, books, supplies, and equipment required to enroll or attend an eligible educational institution.
For Income Purposes
If you receive distributions from your IRA that are less than your required minimum distribution (RMD), the IRS may let you take a penalty-free withdrawal to cover the difference.
How to Avoid Early Withdrawals
There are some ways to avoid taking early withdrawals from your retirement account.
- Take Advantage of Promotional Credit Card Offers. Consider using introductory credit card offers, which also involve 0% interest for some time. It could assist you in financing your spending needs instantly.
- Build an Emergency Fund. You can also try to have an emergency fund covering at least three to six months of living expenses. It will help you to avoid liquidating investments in case of unplanned events or job loss.
- Try to Seek Help From Friends and Family. If you are in a difficult financial situation, do not be too afraid or proud to seek help from your friends or family. They are more forgiving than financial institutions.
- Take Out a Personal Loan. You can also take out a personal loan from a bank or online lender to cover your expenses. Just make sure that you compare rates and terms before you apply. However, the amount you can borrow will vary on variables like your credit score and income level because personal loans are unsecured.
- Use a Portfolio Line of Credit. If you have investments, you may be allowed to use a portfolio line of credit to access cash without selling your investment. This can be a fine option if you think the value of your investments will go up in the future.
Bottom Line
The early withdrawal penalty is a way for the IRS to discourage taxpayers from tapping into their retirement savings before they come to retirement age.
There are some exceptions where you can avoid paying the penalty, such as using the money to pay for qualified higher education expenses or to cover the cost of health insurance premiums while you're unemployed.
Suppose you do not qualify for any of these exceptions. In that case, you can still do some things to avoid taking an early withdrawal, like taking advantage of promotional credit card offers or building up an emergency fund.
FAQs
1. Can I avoid the early withdrawal penalty if I'm using the money for a down payment on a house?
Yes, first-time home buyers are subject to penalty-free withdrawal, provided they have not owned a home in the past two years.
2. How much can I withdraw without being subject to the penalty?
When you buy a home, you can take more than one penalty-free withdrawal, but there is a limit of $10,000.
3. What if I can't afford to pay the penalty?
If you can't afford to pay the penalty, you may be able to negotiate with the IRS to set up a payment plan. You can also try to ask for help from friends and family or take out a personal loan.
4. What is the distinction between a 401(k) and an IRA?
A 401(k) is a retirement savings plan sponsored by an employer. An IRA refers to a retirement savings plan you can set up independently. The 401(k) provides more flexibility regarding contributions and withdrawals. With an IRA, you're generally only allowed to contribute a certain amount each year.
5. I'm retired. Can I still make penalty-free withdrawals from my IRA?
Any withdrawals you make automatically become penalty-free if you are above age 59 ½ when you decide to do so.
