Taxes

The IRA Early Withdrawal Penalty: How to Avoid the 10% Penalty

By Chris Duderstadt

June 5, 2023

The IRA Early Withdrawal Penalty: How to Avoid the 10% Penalty

Key Points – The IRA Early Withdrawal Penalty: How to Avoid the 10% Penalty

  • Reviewing Ed Slott’s 20 Exceptions to the IRA Early Withdrawal 10% Penalty
  • What Is the 10% Penalty?
  • Why Would Someone Want to Withdrawal Before They’re 59½?
  • Briefly Touching on Prohibited Transactions
  • 10 Minutes to Read | 23 Minutes to Listen

Reviewing 20 Exceptions to the IRA Early Withdrawal Penalty

Are you aware of the potential pitfalls of early withdrawals from your retirement accounts? Dean Barber and Bud Kasper are going to take a deep dive into the IRA early withdrawal penalty and the exceptions to the 10% penalty. On America’s Wealth Management Show, they reviewed the 20 exceptions to the IRA early withdrawal penalty that were outlined by their good friend, America’s IRA Expert Ed Slott, at Ed Slott’s Elite IRA Advisor GroupSM spring workshop in Baltimore, which they both attended.

Proud Charter Members of Ed Slott’s Elite IRA Advisor GroupSM

Dean and Bud are charter members of Ed Slott’s Elite IRA Advisor GroupSM. Since 2005, they’ve studied with other members of Ed Slott’s Elite IRA Advisor GroupSM to understand the tax laws that surround IRAs. There are so many trap doors that people step into because they didn’t understand the rules. Unfortunately, the IRS doesn’t give you do overs.

“This is not like playing golf where you hit one into the woods and you take another one out of your pocket and you hit another one. You can’t have a mulligan here.” – Dean Barber

We’ll be reviewing a wide range of exceptions within Ed’s 20 exceptions to the IRA early withdrawal penalty. The goal is to help you navigate the complex world of early withdrawals without incurring hefty penalties. We want to provide you with information that you need to make informed decisions regarding your retirement savings. We’re going to discuss the importance of proper planning, tax implications, and alternative approaches to accessing the funds when needed.

What Is the IRA Early Withdrawal 10% Penalty?

Before we rattle off the list of Ed’s 20 exceptions to the IRA early withdrawal 10% penalty, we need to explain what the IRA early withdrawal penalty is. The early withdrawal penalty comes into effect if you are under 59½ and you take money out of your IRA or 401(k). You would be subject to a 10% penalty, but there are 20 exceptions.

IRAs Have Been a Hot Topic on America’s Wealth Management Show

We’ve been discussing IRAs a lot lately on America’s Wealth Management Show. Last week, Bud and Dean shared some pros and cons of converting to a Roth IRA. They’re going to address a question that received from Joyce on YouTube about converting to a Roth IRA before the dive into Ed’s list of 20 exceptions to the IRA early withdrawal penalty. Here’s Joyce’s question.

“Can you touch base with self-directed Roth IRAs and checkbook control, also with rules for family members like a disqualified person and prohibited transactions?” – Joyce from YouTube

We think that Joyce is talking about owning real estate in her Roth IRA. When you look at prohibited transaction rules, they are applicable to IRAs. The rules prohibit not what your IRA can invest in, but who your IRA may engage in with the transaction.

Gaining a Better Understanding of Prohibited Transactions

Let’s say that you’re wanting to buy a rental property from one of your parents with your IRA. The prohibited transaction rules restrict you from doing so because of who you’re buying the rental property from, not because of you’re wanting to use your IRA.

“You need to be very careful. If you have rental property inside of an IRA or a Roth IRA, it’s fine. You just need to make sure that you follow the very specific rules of owning real estate inside of an IRA. With prohibited transactions, you can’t have any personal benefit or personal use of that real estate. That includes your family members.” – Dean Barber

Here’s another example. Let’s say that you own a beautiful rental property on the beach and you decide to let your kids spend a few days at the property. That’s a prohibited transaction. When you have a prohibited transaction, that basically blows up the entire IRA and makes the whole thing become taxable. And in the case of the Roth, it’s not taxable. But a prohibited transaction would make your Roth IRA not tax-free anymore, and that’s a big deal.

“That’s what we refer to as self-dealing. It’s when there’s an advantage greater than the advantage that the IRA was created to accomplish.” – Bud Kasper

Ed Slott’s List of 20 Exceptions to the IRA Early Withdrawal 10% Penalty

Now, let’s get to Ed’s 20 exceptions to the IRA early withdrawal penalty. We’re going to review them and add a little bit of detail as we go along.

1. Distributions Made After Age 59½ Aren’t Subject to the 10% Early Distribution Penalty

This is the most well-known way to avoid the IRA early withdrawal penalty before breaking up the other exceptions into different categories.

Applicable to All Plans and IRAs

2. Disability

Distributions made to account owners while the owner is disabled aren’t subject to the 10% early distribution penalty.

This IRS has a stiff definition of disability. When Dean and Bud were in Baltimore for the Slott workshop, there was a private letter ruling that they reviewed where someone was disallowed the exception to the 10% penalty because he misunderstood the definition of disability.

3. Death

Distributions made to beneficiaries after the death of the account owner aren’t subject to the 10% early distribution penalty. This one speaks for itself.

4. Medical Expenses

The distribution can’t exceed the amount allowable as a federal income tax deduction to the IRA owner for medical expenses more than 7.5% of average gross income in the year of the distribution.

The medical expenses must be paid in the same year as the distribution. Expenses can be for account owner, spouse, or dependent. Examples of those expenses include dental, prescription drug, and health insurance premiums. The IRA owner doesn’t have to itemized deductions to qualify for the exception.

“Make sure you understand these. Don’t just immediately pay for a medical expense out of your IRA. Understand it. Be careful and use caution.” – Dean Barber

5. Series of Substantially Equal Periodic Payments

This is the Rule of 72(t). We like to utilize it if somebody attains the age of 55 and then separates service from their employer, they can leave money in that employer plan and access it without the 10% early distribution penalty. However, the minute that 401(k) is rolled over to an IRA, you’re going to be subject to the IRA early withdrawal penalty unless you have one of those 20 exceptions.

“It’s subject to a formula that you need to follow through the IRS in terms of what you have. You must take out the same amount every year up until you’re 59½ and in a period of time no less than five years.” – Bud Kasper

There is now an exception to the age of 55 as well. That exception is the attainment of age 50 or 25 years of service with the employer. It applies to state and local police, firefighters, emergency medical service workers, corrections officers and forensic security employees, certain customs officials, border protection officers, air traffic controllers. The list goes on and on. There are people that can access their retirement assets of their employer plan at age 50. This isn’t your IRA. This is your employer plan without the 10% penalty.

The Rule of 72(t) Past and Present

In the 1980s, a lot of people under 59½ in middle management were offered buyouts. Think back to the “Baby Bells” and that divestiture process. The Rule of 72(t) was used quite often.

“Occasionally, we’ll see people retiring now who are under the age of 55. Most of those people have done a pretty good job of saving some money outside of their retirement account. But during that time in the 1980s, most of people’s money was in was a lump sum distribution from their pension and 401(k) plan.” – Dean Barber

6. IRS Tax Levy

The IRS takes the funds from your account. A distribution to you to pay the tax levy is subject to the penalty. This is Dean’s favorite exception to the IRA early withdrawal penalty.

7. Rollover of Eligible Assets to Another Tax Deferred Account

If you roll your plan over from a 401(k) to an IRA, there’s no 10% penalty. But you’re restricted to one rollover per 12-month period. It’s not per calendar year; it’s every 12 months.

“If you exceed that, then guess what? You’re going to have a 10% penalty and it’s going to be taxable.” – Dean Barber

8. Conversions to a Roth

If you want to convert to a Roth IRA prior to 59½, you can make that conversion. You need to pay the tax, but you don’t have the 10% penalty.

“COVID brought an opportunity for a lot of people to convert. For people that may have lost their jobs or their income was lower, we used it as opportunity to convert some of their money from their traditional IRA income.” – Dean Barber

Applicable to Employer Plans and IRAs

9. Active Reservists

You must be called to active duty for more than 179 days to qualify.

10. Birth or Adoption

It’s limited to $5,000 per birth or adoption. And it must be taken within the year of birth or adoption. The distributions can be paid back within three years, so that’s a that’s kind of a little nuance there.

11. Health Insurance If You’re Unemployed

There are several stipulations that you must follow to qualify. The IRA owner must be unemployed and have received unemployment compensation under either a federal or state unemployment compensation law for 12 straight weeks in either the current or prior year.

Distribution needs to be made in the year of or after unemployment. The distribution can’t be more than the amount paid in the year of distribution for health insurance for the IRA owner, spouse, and dependents.

The exception doesn’t apply to distributions made for the IRA owner has been reemployed for 60 days. Also, a self-employed individual qualifies for the exemption if they would’ve qualified for unemployment but for the fact that they are self-employed.

Applicable to IRAs Only

12. First-Time Home Buyer

The exception to the IRA early withdrawal penalty applies if the individual purchasing the home has had no ownership interest in a principal residence for the prior two-year period ending on the date of acquisition.

“You could have owned a home, rented for a few years, and then buy another home as long as you didn’t have any home ownership within the prior two years. You’re still considered a first-time homebuyer.” – Dean Barber

There is a lifetime cap on that first-time homebuyer. It’s only $10,000 per IRA owner. You won’t be able to pull out and pay cash for a house with that. That’s even a small down payment with the price of homes out there today.

13. Higher-Education Expenses

This exemption applies to the IRA owner and IRA owner’s spouse, children, and grandchildren, and children and grandchildren of the IRA owner’s spouse. Expenses can include post-secondary education fees, books, supplies, equipment, computers, and computer peripherals if used primarily by the student.

“I like all these exceptions to the 10% rule, but people shouldn’t think that they can use their IRA like a piggy bank. IRA stands for individual retirement account, so it’s generally for retirement. But things happen.” – Dean Barber

Applicable to Employer Plans and IRAs

14. Terminal Illness

This exemption applies to distributions made to an IRA owner or plan participant who has been certified by a physician as having an illness or physical condition which can be reasonably expected to result in death in 84 months or less. You can repay it if you do that within three years.

“Then, you run into the inherited IRA rules, which the SECURE Act and SECURE Act 2.0 have totally changed. Prior to the SECURE Act, they were fine.” – Dean Barber

15. Federally Declared Disasters

The exemption limit for federal declared disaster is $22,000. The taxable income on the distribution can be spread over three tax years and it can be repaid.

“Look at what was happening in Florida with the hurricane. That’s why they have some of these exemptions.” – Bud Kasper

Applicable to Employer Plans Only

16. Qualified Domestic Relations Order (QDRO)

A qualified domestic relations order happens when someone gets divorced. One spouse gets a part of the other spouse’s 401(k).

17. Section 457 Plans

The exemption applies to governmental 457(b) plans only.

18. 401(k) Excesses

If you made an excess 401(k) contribution, the excess amounts can be withdrawn without the 10% penalty.

19. Employee Stock Ownership (ESOP) Plan Dividends

Certain distributions of dividends from employee stock ownership plans aren’t subject to the IRA early withdrawal penalty.

20. PS 58 Costs

Lastly, there’s the PS 58 cost. The taxable cost of life insurance that is reported annually by the employee isn’t subject to the IRA early withdrawal penalty.

Summing Up the 20 Exceptions to the 10% Penalty

Those are the 20 exceptions to the IRA early withdrawal penalty. If you go back through these, most people that are looking for the exception to the 10% penalty are wanting to retire early.

“Your real options are separating service after 55, leaving some money in the 401(k) for those first four-and-a-half years living expenses or going with option No. 5, which was the 72(t) model. That one is complicated enough in and of itself. The problem is if you mess up that 72(t) five years in, then every dollar you’ve taken out to that point becomes automatically subject to the 10% penalty.” – Dean Barber

Whether you’re looking to retire early or simply just want to have clarity and confidence as you get to and through retirement, we strongly encourage you to download our Tax Reduction Strategies guide. It illustrates how important it is to utilize tax planning strategies, which are geared to make you pay as little tax as possible over your lifetime, not just in one year. You can download a copy of our Tax Reduction Strategies guide below.

IRA Early Withdrawal Penalty

Tax Reduction Strategies

The whole purpose of this is to make people aware that there are exceptions out there. Many of them are rarely used, but there are certain circumstances where they can come into play. We do our best to make the rules work in people’s advantage in those certain situations.

“The one big takeaway here for everybody should be that if you need to get money out of your IRA or 401(k) prior to 59½, get professional help. Don’t touch anything until getting professional help.” – Dean Barber

Getting Professional Help at Modern Wealth Management

Of course, we can offer that professional help at Modern Wealth Management. If you have questions about how to avoid the IRA early withdrawal penalty and how it can impact your retirement, you can schedule a meeting with one of our CFP® Professionals. Click here to schedule a 20-minute “ask anything” session or complimentary consultation, which can be in person, virtually, or by phone.

If you’re not quite ready to meet with a professional yet, we have another way that we can help you as you’re planning for retirement. We’re giving you the opportunity to utilize our industry-leading financial planning tool to begin building a comprehensive financial plan. That’s really the key to gaining more confidence, freedom, and time in retirement. To start building a plan that’s unique to you, click the “Start Planning” button below.

IRA Early Withdrawal Penalty

START PLANNING

And again, if you have questions about anything throughout the retirement planning process, whether it’s about IRA rules or whatever it may be, please don’t hesitate to reach out to us. We hope that Ed’s list and Dean and Bud’s additional insight about the IRA early withdrawal penalty and how to avoid it can be beneficial to you.

The IRA Early Withdrawal Penalty: How to Avoid the 10% Penalty | Watch Guide

00:00 – Introduction
00:55 – Educating Ourselves on IRAs
03:20 – What Is the IRA Early Withdrawal 10% Penalty?
03:39 – Answering a YouTube Question on Roth Conversions
07:27 – Ed Slott’s 20 Exceptions to the Early Withdrawal Penalty
08:43 – Details on Exceptions
20:26 – What We Learned Today

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.