When it comes to retirement plans, people sometimes would like to access their money before they retire. But if taken too early, or in the wrong way, taxes as well as a 10% early withdrawal penalty can occur. You know the old saying about death and taxes. We are going to look at some of the rules for withdrawing funds from IRAs as well as employer plans. In particular we will be talking about the exceptions to the early withdrawal penalties to these plans.
What happens if you try to take money from these plans too early or for the wrong reason?
You will most likely pay an early 10% distribution penalty imposed by our favorite charity, the IRS. Now keep in mind, you’ll never get out of paying the regular tax, but you might be able to avoid the early 10% penalty.
Now, we would like to remind everyone that your retirement funds are to, well, fund your retirement! Not to be withdrawn and consumed early – unless of course you plan on moving in with your kids. Besides, taking out your retirement funds early is very inefficient because you will most likely pay early withdrawal penalties along with regular income tax – it gets pretty ugly, pretty fast. Ok, now that the ‘It’s for your retirement lecture’ is out of the way, what are the exceptions to the early penalty?
The exceptions for the 10% early penalty comes in 3 categories (feels like a game show):
- Exceptions that apply to both company and IRA plans.
- Exceptions that apply only to company plans.
- Exceptions that apply only to IRA plans.
First here are the exceptions to the 10% penalty that apply to both company and IRA plans:
- The first one is easy – death. That seems reasonable don’t you think. No early penalties in this case.
- The next one is disability. Another one is Rule 72(t) – named after the IRS code itself, substantially equal periodic payments is a strict method to take income from retirement accounts early without the penalty.
- Medical expenses
- This next one is interesting: the IRS has graciously allowed an exception in order to pay an IRS levy! They have our backs!
- The last exception is for active reservists
Exceptions only for IRAs:
Here are the exceptions that only apply to IRAs:
- Higher education expenses
- First time home buyer
- Health insurance if you are unemployed
For employer plans only:
- Age 55 (the age is 55 for most employer plans, not 59 ½ like IRAs).
- Age 50 for public safety employees
- 457 governmental plans - A big advantage of 457(b) plans is they are NOT subject to the age 59 1/2 withdrawal rule. This means there is NO 10% penalty for early withdrawal. (Note: This applies only to public (governmental) plans. Private 457 plan participants generally will pay federal income taxes when funds are made available to them).
- Divorce – pursuant to a qualified domestic relations order (QDRO), an employer sponsored retirement plan (like a 401k plan) can be split so a divorced-spouse payee can then receive the funds to an IRA without penalty. IRAs can be split in the same manner under a divorce decree.
You have to make sure you use the right exception for the right plan! The biggest mistakes happen for the first time home buyer and higher education exceptions.
Here is a simple example:
A school teacher withdrew $67,000 from her 403b plan. She then used the money for college education expenses. She paid the regular income tax but not the early 10% penalty because she believed the exception for higher education expenses applied to her retirement plan. It does not, so she had to pay the 10% penalty.
The 10% exception for higher education only applies to IRAs and NEVER to employer/company sponsored plans. Hopefully now you can better understand the importance of matching the appropriate exception to the appropriate plan. When it comes to retirement plans, there are many taxable booby traps if you are not aware of the rules! Remember, it’s always easier to avoid a mistake than it is to solve one! If you really want to avoid these costly mistakes, the easiest way is to call us and let us safely walk you through it.
Thank you for reading!
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.