Avoiding the Penalty on Early Retirement Plan Withdrawals

The money that you’ve built up in a retirement savings account can look tempting at times, particularly in an uncertain economy. If you feel you have no choice but to withdraw from a retirement account, you may find that it’s a costly option because of the potential taxes and penalties involved.

The California Society of CPAs explains the price you’ll have to pay and how the exceptions to the rules work.

A Double Whammy

Generally, if you take an early distribution from a qualified retirement plan or deferred annuity contract before age 59½, you will be hit with a double whammy of penalties. First, you will have to pay ordinary income taxes on your withdrawal. In addition, you’ll face a 10 percent penalty on the amount because of the early withdrawal. Those two rules apply to 401(k)s and traditional IRAs.

With a Roth IRA, a qualified distribution escapes taxes and penalties, but a non-qualified distribution does not. Since the distinctions between the two are complicated, be sure to consult your CPA for more information. In all cases, the taxation and penalty don’t apply to distributions that are rolled over into another qualified retirement plan.

How Do Exceptions Work?

There are several exceptions to the penalties. Retirement plans may permit withdrawals when there is an “immediate and heavy” financial need. The Internal Revenue Service notes that needs that fit this definition may vary based on each situation. If you have other resources to address the need, however, there would be no exception

The need may relate to yourself, your spouse or a dependent. In its guidance, the Internal Revenue Service includes funeral or medical expenses in this definition.

Education and Health Exceptions

There are also exceptions relating to education and health concerns. The penalty generally doesn’t apply (although the tax may) for withdrawals made to cover qualified higher education expenses for yourself, your spouse or your children or grandchildren.

When it comes to health concerns, you may take early withdrawals if you are totally or permanently disabled. In addition, you can tap into your retirement funds to cover medical expenses that add up to more than 7.5 percent of your adjusted gross income. Only deductible medical expenses paid in the year the distribution is taken qualify for the exception.

Medical Insurance for the Unemployed

You can also take a penalty-free early distribution for health insurance premiums if you are unemployed, have received unemployment compensation for at least 12 consecutive weeks and have taken the distributions during the same year in which the unemployment compensation is made, or the succeeding year. These payments, however, are limited to the actual amount paid for insurance for the employee, his spouse and their dependents.

Self-employed taxpayers qualify for this exemption if self-employment is the only reason they do not qualify for unemployment compensation.

Purchase of a Principal Residence

A qualified first-time homebuyer can take a distribution and escape the 10 percent penalty to the extent that the distribution is used by the individual to pay a qualified acquisition cost for a principal residence. Distributions can be up to $10,000 during the individual’s lifetime, provided they are used within 120 days of withdrawal to buy, build or rebuild a first home that is the principal residence of the individual, his or her spouse or any child, grandchild or ancestor of the individual or spouse.

Taking Periodic Payments

Another exception comes into play in certain circumstances when you take distributions in a series of substantially equal periodic payments over your own life expectancy or the life expectancies of yourself and your designated beneficiary. These withdrawals must be taken at least annually, and there are complicated approaches to calculating them and ensuring that they remain tax free. Be sure to contact your CPA if you want more information.

Additional Considerations

There are no penalties if you withdraw funds under a qualified domestic relations order in a divorce case or if you use them to satisfy an IRS levy. Money paid to your beneficiary or your estate also escapes the penalty. Military reservists who have been called to active duty for at least 180 days can also withdraw from their retirement accounts without facing a penalty.

Consult Your CPA

Generally, if you need money in a pinch, it’s best to draw first from your emergency funds or from any investments that you have. If you don’t have a nest egg available and are seriously considering withdrawing from a retirement account, given the complexity of the rules on retirement plan withdrawals, be sure to turn to your local CPA. He or she can provide advice on all your financial questions.

Copyright 2012 American Institute of Certified Public Accountants.

The Money Management columns are a joint effort of the AICPA and the California Society of CPAs as part of the profession’s nationwide 360 Degrees of Financial Literacy program.

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