IRA rules are designed to discourage early distributions, and a 10% penalty is imposed on distributions taken prior to the IRA holder reaching age 59½. However, the law provides several exceptions to the penalty, which include:
|Beneficiary(ies) of a Deceased IRA Owner
|Birth or Adoption of Child
|One-Time Rollover to a Health Savings Account (HSA)
|Purchase of a First-Time Home
|Rollover to an IRA or Retirement Plan
|Distributions for Individuals Called to Active Duty
|Substantially Equal Periodic Payments (Rule 72(t))
|Higher Education Expenses
|Unreimbursed Medical Expenses
Beneficiary(ies) of a Deceased IRA Owner
Beneficiaries may withdraw assets from an inherited IRA without a 10% penalty regardless of their age.
Birth or Adoption of a Child
Under provisions of the SECURE Act, individuals may now take a penalty-free withdrawal of up to $5,000 per parent from a retirement plan within a year of birth or adoption for qualified expenses.
Upon the death of an IRA holder, assets distributed from the IRA to beneficiaries will not be subject to the 10% penalty.
If an IRA holder meets the definition of “disability,” a distribution may be taken from the IRA without incurring the 10% early distribution penalty.
Under the Internal Revenue Code, an individual is considered disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued or indefinite duration. If the individual files an IRS Schedule R, Credit for the Elderly or Disabled, he or she may wish to provide a copy to the IRA custodian.
Distributions for Individuals Called to Active Duty
Military reservists called to active duty for a period of more than 179 days, or for an indefinite period, may take penalty-free distributions from their IRAs and employer-sponsored retirement plans by the close of the active duty period.
Higher Education Expenses
An IRA holder may take distributions from their IRA to the extent that such distributions do not exceed the qualified higher education expenses at an eligible educational institution of the taxpayer, spouse, or his or her dependents for the taxable year. Dependents include any child or grandchild of the taxpayer or the taxpayer’s spouse.
“Qualified higher education expenses” generally include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. In addition, if the individual is at least a half-time student, reasonable costs for such period incurred for room and board while attending such institution are also considered qualified higher education expenses.
An eligible educational institution is any college, university, vocational school, or other post-secondary educational institution that is eligible to participate in the student aid programs administered by the Department of Education. Virtually all accredited public, nonprofit, and proprietary post-secondary institutions are eligible educational institutions.
There are no dollar limitations under the higher education penalty exception.
The 10% penalty is waived for amounts debited from an IRA as a result of an IRS levy. Note that the wavier does not apply to distributions taken from an IRA by the holder to satisfy the taxes owed in order to avoid the levy.
Penalty-free distributions from IRAs to pay for medical insurance apply if each of the following conditions occur:
- The IRA holder loses his or her job
- The IRA holder receives unemployment compensation paid under any federal or state law for 12 consecutive weeks
- IRA distributions are taken in either the year the IRA holder receives the unemployment compensation or the following year
- The IRA holder takes an IRA distribution no later than 60 days after he or she has been reemployed
The medical insurance policy purchased may cover the IRA holder and his or her spouse and dependents.
One-Time Rollover to a Health Savings Account (HSA)
The rollover is limited to the maximum HSA contribution for the year, minus any contributions previously made. For 2023, the limit is $3,850 for self-only and $7,750 for family plans ($1,000 catch-up if age 55 or older). If the individual fails to remain HSA eligible for 12 months from the rollover date, the amount of the rollover will be treated as ordinary income and the 10% penalty may apply.
Purchase of a First-Time Home
A qualified first-time home purchase expense is any distribution used by the IRA holder before the close of the 120th day after the date of receipt for the acquisition costs of a principal residence by a first-time homebuyer who is the IRA holder, the IRA holder’s spouse, or the IRA holder’s child, grandchild, or ancestor of the IRA holder or spouse.
Qualified acquisition costs include the costs of acquiring, constructing, or reconstructing a residence, including any usual or reasonable settlement, financing, or other closing costs. The aggregated lifetime expense cannot exceed $10,000.
A first-time homebuyer is defined as an individual that had no present ownership interest in a principal residence during the two-year period ending on the date of acquisition of the principal residence.
Rollover to an IRA or Retirement Plan
IRA holders are allowed to take 1 IRA distribution and roll it to the same or a like IRA within 60 calendar days once in a rolling 12 month period per social security number. If the entire IRA distribution is rolled over, this will negate any taxability and penalty on the distribution. IRA owners are also allowed to roll IRA distributions to certain qualified retirement plans, as long as it is allowed by the plan document.
Substantially Equal Periodic Payments (Rule 72(t))
The penalty is waived for IRA holders who receive a series of substantially equal periodic payments (Rule 72(t)) based on life expectancy, calculated by one of three methods prescribed by the IRS.
Rule 72(t) payments begun before age 59½ must continue unchanged for five years or until the IRA holder reaches age 59½, whichever is later. Altering these payments results in payment of the 10% penalty on all distributions. However, the five-year rule is waived upon death or disability.
Unreimbursed Medical Expenses
IRA holders are not required to pay the 10% early distribution penalty for IRA withdrawals taken to pay for unreimbursed medical expenses that are greater than 7.5% of the individual or married couple’s Adjusted Gross Income (AGI).
According to IRS Publication 590-B, Individual Retirement Arrangements (IRAs), an IRA holder can only take into account unreimbursed medical expenses that he or she would be able to deduct as an itemized medical expense deduction on Schedule A, Form 1040, U.S. Individual Income Tax Return. Publication 590-B also clarifies that an IRA holder does not need to itemize deductions to take advantage of this exception to the 10% early distribution penalty.
Ordinary Income Tax
While penalty exceptions eliminate the 10% early withdrawal penalty, it is important to note that such distributions are still subject to ordinary income tax, if applicable.Please note that IRA holders under age 59½, who apply one of the penalty exceptions toward a distribution from their IRA, should be confident that they meet the definition and requirements. Stifel is not responsible for determining whether an IRA holder meets the requirements for taking a penalty-free distribution from an IRA. It is always recommended that they seek the aid of a competent tax advisor or tax attorney to assist with tax advice and guidance.
Stifel does not provide tax advice. You should consult with your professional tax advisor regarding your particular situation.