Whenever you take a premature distribution from your Individual Retirement Account (IRA) you have to pay a 10% penalty on the taxable amount of the distribution in addition to federal income tax. However there are 9 exceptions that you can use to avoid paying that 10% penalty which are as follows:
- Withdrawals That Count as Substantially Equal Periodic Payments (SEPPs). This exception is the same as the one for qualified retirement plan withdrawals, except separation from service is not required. The rules for SEPPs require you to receive a series of annual payouts. This is similar to an annuity which pays you an equal stream of payments for a set period. If you have several IRAs, you do not need to withdraw from them all. You only need to annuitize one or more of the IRAs to generate annual SEPPs that are big enough to meet your cash needs. However, the entire balance in all your IRAs must be considered and annuitizing only a portion of an IRA does not qualify for this exception. Unfortunately, the SEPP exception has two important requirements that you need to be aware of:
- (1) Once begun, the SEPP must continue for at least five years or, if later, until the owner reaches age 59 1/2. If the SEPPs are stopped too soon, all the previous age 59 1/2 withdrawals that were thought to have been taken under the SEPP exception are subject to the 10% penalty tax. The same thing can happen if the annuitized account is modified during the period when SEPPs are required, for example by making annual contributions to that account or by rolling over all or part of that account into another account.
- (2) Annual SEPP amounts must be calculated correctly. If the correct annual amounts are not withdrawn, it is deemed to be a prohibited modification of the SEPP, which results in all the previous age 59 1/2 withdrawals that were thought to have been taken under the SEPP exception being hit with the 10% penalty tax.
- Withdrawals for Medical Expenses in Excess of 10% (or 7.5% if you or your spouse are over 65) of Adjusted Gross Income (AGI). This exception is the same as the one for qualified plan withdrawals.
- Withdrawals by Military Reservists Called to Active Duty. This exception is the same as the one for qualified plan withdrawals.
- Withdrawals for IRS Levies. This exception is the same as the one for qualified plan withdrawals. Note that this exception is unavailable when the IRS levies against the IRA owner (as opposed to the IRA itself), and the owner then withdraws IRA funds to pay the levy.
- Withdrawals after Death. This exception is the same as the one for qualified plan withdrawals. Note that this exception is not available for funds rolled over into a surviving spouse’s IRA or if the surviving spouse elects to treat the inherited IRA as her own account. Therefore, the surviving spouse should leave amounts that will be needed before age 59 1/2 in the inherited IRA. This way, the 10% penalty tax can be avoided on those amounts.
- Withdrawals after Disability. This exception is the same as the one for qualified plan withdrawals.
- Withdrawals for First-time Home Purchases. This exception applies only to IRAs. It allows penalty-free withdrawals (up to $10,000 per lifetime) to the extent the account owner uses the funds within 120 days to pay for qualified acquisition costs for a first-time principal residence. The principal residence can be acquired by: (1) the account owner or the account owner’s spouse; (2) the account owner’s child, grandchild, or grandparent; or (3) the spouse’s child, grandchild, or grandparent. The buyer of the principal residence (and the spouse if the buyer is married) must not have owned a present interest in a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as costs to acquire, construct, or reconstruct a principal residence-including closing costs.
- Withdrawals for Qualified Higher Education Expenses. This exception only applies to IRAs. Early IRA withdrawals are penalty-free to the extent of qualified higher education expenses paid during that same year. Qualified higher education expenses include amounts paid for tuition, books, fees and other related expenses for an eligible student. This amount will be reflected on a form 1098-T that the school will send to the student. However, the qualified expenses must be for the education of: (1) the account owner or the account owner’s spouse or (2) a child, stepchild, or adopted child of the account owner or the account owner’s spouse.
- Withdrawals for Health Insurance Premiums during Unemployment. This exception only applies to IRAs, and is available if you received unemployment compensation payments for 12 consecutive weeks under any federal or state unemployment compensation law during the year in question or the preceding year. If this condition is satisfied, your early withdrawals during the year in question are penalty-free up to the amount paid during that year for health insurance premiums to cover the account owner, spouse, and dependents. However, early withdrawals after you regain employment for at least 60 days don’t qualify for this exception.
If you took a distribution from your IRA and received a form 1099-R with a distribution code of 1, and feel you meet one of exceptions listed above, please contact Gregory J. Spadea at 610-521-0604 of Spadea & Associates, LLC located in Ridley Park, Pennsylvania.