Qualified retirement plans are designed to be used solely for retirement income. Taxable withdrawals from these plans before age 59.5 are generally assessed an additional 10% “early distribution tax” by the IRS. (The additional tax for SIMPLE IRA plans is 25% in the first two years of participation, and 10% thereafter). However, there are exceptions to this tax. Most of the exceptions apply to both individual retirement accounts and employer sponsored qualified plans, while a few only apply to IRAs. It may be possible, however, to roll a portion of your company’s retirement plan to an IRA in order to take advantage of those exceptions that only apply to IRA plans.
If you become disabled you can access your retirement funds without penalty, but there’s a catch. To claim the exemption, the IRS requires a “total and permanent” disability. You are only considered disabled if “you cannot engage in any substantial gainful activity because of your physical or mental condition. Additionally, “a physician must certify that the condition has lasted or can be expected to last continuously for 12 months or more, or that the condition can be expected to result in death.”
2. Education (IRAs only)
Distributions to pay qualified expenses for higher education qualify for the exemption if the student is enrolled in at least half of a full-time academic work load at an eligible academic institution. Qualified expenses include tuition, fees, books, supplies and equipment required for the education. These expenses can be for you, your spouse, you or your spouse’s child or grandchild. It is important to note that any expenses paid for with other government program funds or tax benefits are generally not eligible for this exemption. To qualify, the education expenses must be paid in the same year as the withdrawal.
3. First-Time Homebuyers (IRAs only)
Qualified first-time homebuyers can exclude up to $10,000 of penalty-free distributions from the early withdrawal tax if the proceeds are used to buy or build a primary residence within 120 days. The home can be for you, your spouse or either of your descendants. The term “first-time homebuyer” is a little misleading. According to the IRS, you are a first-time home buyer if you or your spouse did not have any ownership in a primary residence during the previous two years. So even if you have owned a home in the past, you can be considered a “first-time” homebuyer if it has been at least two years since you sold it. While this exemption can only be used once in a lifetime, both you and your spouse could each withdraw $10,000 and apply it to the same residence.
4. Unreimbursed Medical Expenses
Any unreimbursed medical expenses that exceed 10% of your adjusted gross income (Line 37 of the Form 1040) can be paid with funds from your IRA or company retirement plan without incurring the early distribution tax. The medical expenses must be paid in the same calendar year as the withdrawal to qualify.
5. Medical Insurance During Unemployment (IRAs Only)
If you lose your job and receive unemployment compensation for at least 12 consecutive weeks you may qualify to pay your medical insurance premiums with amounts withdrawn from your IRA without the early distribution tax. IRA withdrawals can be used to pay medical insurance premiums for yourself, your spouse, or your dependents without the 10% penalty. The distributions must be received in either the year you received unemployment compensation or the next year and must be withdrawn no later than 60 days after you start a new job.
6. Active Duty Military Reservist
If you are a member of the military reserves and are called to active duty for at least 180 days (or for an indefinite period) you will not have to pay the excess tax on any withdrawals made during your period of active duty.
7. IRS Levy
If the IRS places a levy on your retirement plan and you withdraw funds to satisfy the levy, you will not be charged the excess tax. If, however, you withdraw funds to pay taxes owed in anticipation of a levy, the exemption does not apply.
8. Substantially Equal Periodic Payments
If you do not meet any of the aforementioned exceptions, but still want to access your retirement plan without penalty, you can take “Substantially Equal Periodic Payments” over a period that is the longer of five years or until you reach age 59.5. The “Substantially Equal Periodic Payment” must be calculated according to complicated IRS actuarial rules. (You should consult a certified public accountant to perform the calculations.) These payments cannot be stopped or changed once they start or the 10% early distribution tax will be applied retroactively applied and you will also be charged interest.
It is important to weigh the consequences of taking distributions from plans designed to provide retirement income for non-retirement expenses. You should try to find another means to pay these pre-retirement expenses when possible. (If you plan to take out a loan, a good credit score will lead to a better rate. See where you stand before applying. You can check two credit scores for free at Credit.com.) Otherwise, make certain that you seek the advice of a competent tax adviser before making this critical decision. Mistakes can be costly.