Exceptions to the IRA Early Withdrawal Penalty

Estimated reading time: 4 minutes

You might have hit a rough patch financially, or need an extra boost for a big expense, and remember that you have more than enough in your retirement account to pull from for an emergency. The only problem is you haven’t turned 59 ½ yet, so any money withdrawn from your IRA will incur a 10% penalty. Ouch. Luckily, there are a few exceptions to this penalty rule, and you may qualify for at least one of them. Read on to find out when you can accept an early distribution without suffering a stiff penalty for doing so.

  • Education. The IRS allows early withdrawals from an IRA to pay for college tuition, fees, and supplies. They even allow the distribution to be used on room and board as long as the student is at least half-time. The person using the money for education must be you, your spouse, your child, your grandchild, or your parent. One thing to keep in mind when using this method is that any extra income from the IRA may affect your financial aid eligibility.
  • Medical. If you are unlucky enough to need an expensive medical procedure performed that costs more than 10% of your adjusted gross income, you are allowed an early withdrawal to help pay for the expense. The catch is that the expense must not be reimbursed in any way by your insurance company.Another medical related category you may use your IRA money for is toward health insurance if you have been out of work for at least 12 weeks and have been collecting unemployment. The health insurance must be for you, your spouse, and/or your children.
  • Home purchase. If you are a first-time home buyer or haven’t owned a home within the last two years, you may use money from an IRA to use toward buying a home, building or rebuilding a home, for settling, financing, and/or closing costs. The money can also be used by you, a spouse, a child, grandchild, or parent, and must be used within 120 days of withdrawal. A single person can withdraw $10,000 without penalty, and a married couple $20,000 from their combined IRAs.
  • Military. Anybody in the military reserves who has been called into active duty for at least 180 days may take an early withdrawal without penalty. However, they may not take the withdrawal before their orders were given or after their active duty status ends.
  • Disability. A work-ending physical or mental disability will qualify you for an early distribution as long as a physician confirms the disability will result in either death or a continued or indefinite duration. There are no requirements as to what the money may be used for.
  • Death. If an IRA holder suddenly dies, a spouse, child, or other named trustee may make an early withdrawal as long as they claim it as an inherited IRA and refrain from rolling over the account into their own IRA.
    Substantially Equal Periodic Payments. If you’re really in a financial bind and need to use your retirement money for an extended amount of time, the IRS will waive the 10% penalty as long as certain criteria are met. You must take the same amount of money out each time, in which the amount is determined by any one of three IRS methods, for a period of 5 years or until you turn 59 ½, whichever comes later. If you fail to meet these criteria, you may owe 10% on each withdrawal taken.

It’s best to leave IRA funds untouched until you reach age 59 ½ to ensure you have enough to live comfortably at retirement. However, extenuating life circumstances may cause adaptations to the plan. Although the above mentioned exemptions will save you from the 10% early withdrawal fee, you will still have to pay income tax on any funds received from a traditional IRA since all contributions were made tax deferred. With a Roth IRA, you are allowed to make tax-free withdrawals at any time as long as the account is at least five years old and you are withdrawing on contributions only, but not earnings. Remember to always fill out your tax forms correctly to let the IRS know the funds were used under an exempted reason, and always know the rules and limitations of your own IRA.

Fixed Amortization vs. Fixed Annuitization for Early Withdrawals From Your Self-Directed IRA

Estimated reading time: 3 minutes

Self-Directed IRAYou probably already know taking a distribution from your self-directed IRA before you reach retirement will generally trigger a 10% early withdrawal fee, in addition to any taxes that may be due. You may also be familiar with certain exceptions that allow you to make penalty free withdrawals, including those for certain medical expenses, educational expenses, or a down payment for first-time home purchase.

But there is also another, lesser-known provision that you have available, known as a series of substantially equal payments. While it is somewhat more complicated than the other exceptions, and requires a longer term financial commitment, it might be suitable for some individuals in particular circumstances.

This exception allows you to set up a program where you begin taking annual withdrawals from your self-directed IRA prior to reaching age 59 1/2. The schedule of payments can be calculated by either a fixed annuitization method or a fixed amortization method, or the more familiar required minimum distributions method.

Fixed Annuitization. The fixed annuitization method provides the starting account balance by a factor taken from the IRS tables, which is based on mortality rates and a “reasonable” interest rate that cannot be less than 120% of the federal midterm rate. Essentially this method calculates the present value of a $1 per year lifetime annuity of a particular amount for the account holder, and divides this amount by the account balance to determine the annual payout.

Fixed Amortization. This method simply amortizes your account balance over your life expectancy. In general, the fixed amortization method yields a lower annual payment than the fixed annuitization method. When determining the “life expectancy” in the fixed amortization method, the account holder can either choose the calculation based on their life, or the joint life expectancy of themselves and their primary beneficiary.

It’s important to note that once this amount is calculated, it will not change. This means that an account that suffers significant investment losses may be depleted early, while an account that performs particularly well might have a surplus of funds.

Required Minimum Distributions. The third method of setting a schedule of substantially equal payments is to use the required minimum distributions method that applies to traditional self-directed IRA holders once they reach age 72. The biggest difference between this method and the fixed amortization and fixed annuitization methods discussed above is that the required minimum distributions are recalculated every year based on your current account balance.

You are allowed to change between these methods one time during the course of your life.

Once you begin taking substantially equal periodic payments from your self-directed IRA, you must continue to do so for at least five full years, or until you reach age 59 1/2, whichever is later. Therefore, this is not a one-time decision, and not a step to be taken lightly. It might be appropriate for your individual situation, but make sure you understand all the implications before moving forward.