The U.S. government incentivizes individuals to save for retirement with retirement savings plans, such as an IRA or 401(k). However, these accounts come with both a carrot and a stick. The accounts encourage individuals to save for retirement by offering unique advantages such as tax-free earnings, but they also penalize individuals for early withdrawals. Specifically, if an individual withdraws money from a 401(k) or IRA before turning 59 ½, he or she will have to pay a 10% penalty on the money withdrawn on top of income taxes. In a perfect world, no one would have to touch their retirement savings prior to retirement, but the reality of the situation is that life often comes with unexpected expenses. Thankfully, though, there are some IRA & 401(k) early withdrawal penalty exceptions.
Rollover
One of the most commonly used exceptions to early withdrawal penalties is if an IRA or 401(k) is rolled over into another account. For example, if an employee had a 401(k) through their previous employer, he may wish to rollover his 401(k) from the previous employer into the new employer’s 401(k). This can simplify the employee’s finances by limiting the number of accounts the employee must keep track of. There are two important notes to this exception. First, the funds must be rolled into another eligible retirement plan. Secondly, the money must be in the new account within sixty days of withdrawal.
Death
The early withdrawal penalty does not apply to distributions made to beneficiaries who inherit funds from the plan after the death of the individual who owned the plan. This applies to both IRAs and 401(k)s. The exceptions to this rule is if the beneficiary is a spouse, if the beneficiary treats the account as if it’s his or her own, and if the beneficiary is under 59 ½. In that case, the early withdrawal penalty would still apply.
Disability
When individuals become disabled, they are able to withdraw funds from either their IRA or 401(k). For the purposes of this early withdrawal exception, there is a fairly strict definition of disabled. Essentially, the disabled person must be unable to work for a long period of time. There must also be documented proof of the disability supplied by a doctor.
Medical Expenses
Funds from a 401(k) or IRA can be used to cover medical expenses, but only in fairly extreme circumstances. The medical expenses must not be covered by health insurance and the medical expenses must be more than 10% of the individual’s adjusted gross income. Even if this situation applies, it is worth considering if any other payment options exist. Even temporarily going into debt may make more financial sense in the long run. This is because taking distributions will not only minimize the amount saved for retirement, but it also minimizes the future earnings that could have come from the withdrawn funds.
Health Insurance Premiums
Under certain circumstances, unemployed individuals can use money from their IRA (but not their 401(k)) to pay health insurance premiums. In order to avoid the 10% early withdrawal penalty, unemployment compensation must have been received for twelve consecutive weeks in the same year or the year before the funds from the IRA were used to cover health insurance premiums. Further, the withdrawal must be made more than sixty days before beginning a new job.
Home Purchase
First time home buyers can withdraw money from their IRA, up to $10,000, to put towards a home. The money must be put towards the purchase of a home within 120 days after withdrawing the funds. As with many of the other exemptions, there are strict guidelines used to define a first-time home buyer. For example, if either individual in a married couple has previously owned a home, the couple is not eligible for the exemption.
Higher Education
Withdrawals can also be made from an IRA to help cover qualified higher education expenses. The higher education expenses must be those of the owner of the account or the owner’s spouse, child, or grandchild. One effect to be aware of in this situation is that using money from an IRA to cover higher education expenses increases income, which must be reported on the next year’s FAFSA. A higher level of income may have a negative effect on the student’s financial aid.
Whether or Not to Withdraw Early
There’s a reason the early withdrawal penalty exists. Ideally, retirement savings accounts should be used exclusively for retirement. But there are circumstances where using retirement savings may be the only option, and if this is the case, it’s good to know the IRA & 401(k) early withdrawal penalty exceptions. Those who are considering taking money from retirement savings accounts should speak with a team member from Good Life Financial Advisors of Mt. Pleasant to make sure no other options exist before taking this step. We look forward to assisting you.
