Early withdrawals from retirement accounts

Steve Merrell |

The tax advantages of retirement accounts—IRAs and 401(k)s—come with significant strings attached. On the one hand, the IRS requires account owners to take minimum annual distributions once they reach 70 ½ years of age. On the other hand, unless your withdrawal qualifies for an exception, the IRS imposes a 10 percent excise tax on withdrawals taken from these accounts before age 59 ½.

Exceptions to the early withdrawal penalty can be confusing, even for experienced financial advisors. Some exceptions apply to both IRAs and 401(k) plans, while others apply to one and not the other. If you are facing a situation where you might need to take an early withdrawal, be careful to carefully follow the IRS rules on exceptions. According to a recent Kiplinger Tax Letter, early withdrawals are increasingly a “red flag” item for IRS audits.

To help folks stay on the right side of this issue, the IRS has published a table of these exceptions, including which types of accounts they apply to and any limitations or conditions on the withdrawals. The table also references the applicable sections of the Internal Revenue Code. You can find it at: http://bit.ly/2mfNeSM.

. For those who want a little more straight-forward discussion, here is a summary of some of the more common exceptions. Please remember that all withdrawals from traditional IRAs and 401(k) plans will be taxed as current income. These exceptions apply only to the early withdrawal penalty.

  1. First-time home buyers. First-time home buyers can take up to $10,000 from their IRAs penalty-free to buy or build their primary residence. Like a lot of government regulations, this doesn’t really mean what it says. In this case, a “first time” buyer can be anyone who hasn’t owned a home for the past two years. In addition, it doesn’t have to be your own home. A home for your spouse, child, grandchild, parent or grandparent also qualifies. This exception is not available for withdrawals from 401(k) plans.
  2. Higher education. An exception is available to pay for higher education, including the cost of tuition, fees, books, computers, supplies, and room and board. To qualify for this exception, the student must be the IRA owner, her spouse, child or grandchild. There is no dollar cap on this exception. This exception is not available for 401(k) plans.
  3. Large medical bills. If you, your spouse or a dependent face large unreimbursed medical bills, you may be able to take penalty-free distributions from both your IRA and 401(k). There is no dollar limit on the amount you can withdraw, but only medical expenses that exceed 10 percent of your adjusted gross income qualify for the exception.
  4. Health insurance. If you are unemployed, you can take penalty-free distributions from your IRA to pay for health insurance. This exception is not available for 401(k) plans.
  5. Substantially equal periodic payments. This key withdrawal strategy applies to IRAs, 401(k)s and deferred annuities and although it is somewhat complex, it can be very powerful. This exception requires you to calculate a periodic payment using one of three approved methods and then maintain that level of distribution for five years or until you turn 59 ½, whichever is longer. The actual calculation is beyond the scope of this column, but an experienced advisor can help you with it. Be aware that if you change the payment after you have started taking withdrawals, all the previous periodic payments will become subject to the 10 percent early withdrawal penalty.

You can also take penalty-free distributions from your IRA and 401(k) if you become totally and permanently disabled. The Internal Revenue Code does not provide for any general “hardship” exceptions.

Of course, early distributions from a retirement plan should really be a last resort. Before taking early withdrawals from a retirement account, work closely with your financial advisor to see if there are other better ways to cover your current financial needs.


Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to steve@montereypw.com.