Avoiding The IRA Early Withdrawal Penalty
Guest post from David Waldrop, CFP® with Bridgeview Capital Advisors, Inc.
Individual Retirement Accounts (IRAs) have special advantages when compared to traditional investment accounts. With an IRA, the account owner incurs no annual tax liability resulting from interest, dividends, and capital gains. As long as there are no withdrawals (distributions) from the IRA, the account owner receives no 1099 tax form. This tax deferral allows the earnings within the account to grow free from annual taxes until you actually need the funds in retirement. This favorable tax treatment of IRAs is designed to provide an incentive to invest for your retirement.
When you withdraw from an IRA, the amount is included in your taxable income. However, if you’re under age 59 1/2 and you take a withdrawal from an IRA, you should plan on paying the dreaded 10% early distribution penalty in addition to your ordinary income taxes. For example, let’s assume you’re 45 and your tax rate is 28%. If you take $10,000 from your IRA, you would owe income tax of $2,800 and an additional penalty for early distribution of $1,000. This early withdrawal of $10,000 cost you $3,800 and that doesn’t even include taxes your state may impose.
Fortunately, there are some exceptions to this 10% penalty which can help soften the blow of taking an early distribution. Please note, this is general in nature and should not be relied upon alone in determining whether you’re eligible for the exception.
Medical expenses: This applies when unreimbursed medical expenses are in excess of 10% of your adjusted gross income or AGI.
Medical insurance: If you’ve lost your job and have received unemployment compensation for 12 consecutive weeks, amounts you pay for medical insurance for yourself, your spouse, and your dependents can be exempt from the 10% penalty.
Disabled: When you can provide proof that you have become disabled and that the condition is expected to be long or permanent, the early distribution penalty will not apply.
Distributions to a beneficiary or estate due to an IRA owner’s death: Your IRA won’t be subject to a penalty for early distribution if you pass away and your beneficiary receives the funds.
Substantially equal payments: You may elect to receive “substantially equal” payments based on your life expectancy. This is sometimes referred to as taking payments in the form of an annuity.
Higher education expenses: These expenses must be considered “qualified higher education expenses” and the education must be for you, your spouse, children or grandchildren.
Qualified reservist distributions: If you are a member of the military reserves, distributions taken during active duty may avoid the 10% penalty.
Qualified first-time home buyer: If you buy, build, or rebuild a first home, up to $10,000 may be exempt from the 10% early distribution penalty.
Taking an early distribution from an IRA is huge financial decision with potentially serious consequences. More detail on this subject can be found at the IRS website. While retirement accounts should not be used as piggy banks, life has a way of throwing us curve balls. If you’ve found yourself in a bind and withdrawing early from your IRA is the only option, proceed with caution. There are pitfalls in each of the situations listed above. If you plan taking an early distribution, be sure to consult your financial professional or tax advisor.
David Waldrop, CFP® is the President of Bridgeview Capital Advisors, Inc. located in El Dorado Hills, California. You can find out more about David at Bridgeview Capital Advisors' website or on his blog The Astute Advisor.
David Waldrop is not affiliated with Castlebar Asset Management, LLC.
Please contact us at 913-871-7980 or by email to discuss your financial planning and investment management needs.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.