6 Types of Penalty-Free IRA Withdrawals

Tom Petty once sang that “the waiting is the hardest part” and IRA holders can relate to that feeling all too well. Both traditional and Roth IRAs have certain restrictions on when the account holder can withdraw their funds. Since these accounts are meant for retirement savings, the IRS will levy a penalty of 10% on all withdrawals made before age 59 1/2 unless unique situations apply.

Of course, these ‘unique situations’ aren’t all that unique, and many IRA owners can squeeze themselves into the criteria needed for a penalty-free withdrawal. Note that penalty-free doesn’t mean tax-free: you’ll owe taxes on any withdrawal from a traditional IRA regardless of whether it’s penalized or not. And if you have a Roth IRA, you can withdraw any of your basis at any time without penalty or tax. In this post, we’ll walk you through 6 types of penalty-free IRA withdrawals.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

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1.   First Time Home Buying

Buying a home is one of the largest purchases made by the average American. The government realizes that homeownership is a major plus, so the IRS has created an exemption where first time home buyers can tap the equity in their IRA accounts for a house without getting penalized.

To qualify as a first-time home buyer, you cannot have owned a home at any point in the preceding two years. Yes, ‘first time’ has a short shelf life and many long-time home owners can qualify for this exemption if they sell their home and rent for 24 months. Withdrawn funds can be used for buying, building, and repairing, but this exemption has a lifetime limit of $10,000 per individual.

2.   Excessive Medical Costs

Another common penalty-free IRA withdrawal is for unreimbursed medical expenses. For example, if you suffer a major injury and have significant costs not covered by insurance, you can withdraw money to cover these expenses provided the unpaid amount exceeds 10% of your adjusted gross income (up from 7.5% in previous years). The withdrawal must be made in the same year the medical costs were incurred.

Another penalty-free medical withdrawal regards health insurance premiums while unemployed. If you’ve been out of work for at least 12 weeks and are paying for health insurance out of pocket, the IRS will allow a penalty-free withdrawal to cover the monthly premiums.

3.   Death and Disability

If you become permanently disabled, you’ll be allowed to tap your IRA immediately without being slapped with the 10% penalty. Taxes will still apply and your administrator will likely need proof of the disability before allowing disbursement. The disability must be total and permanent to have the 10% penalty waived.

Additionally, if the original IRA holder dies before exhausting the funds, the inheritor of the account can make withdrawals and not be penalized. The only wrench in this plan is if your IRA is inherited by a spouse who transfers the balance into their own IRA. In this scenario, the IRS considers that IRA to belong to the spouse, so the 10% penalty still applies if distributions are taken before age 59 ½.

4.   Active Military Service

A reservist who is called into active military duty may make withdrawals from their traditional IRA without getting penalized if certain criteria are met. Pretty much all service branches are eligible for this exemption, but they must be called to active duty after Sept 11, 2001 and serve at least 180 days. The withdrawal MUST be made during the period of active service or the 10% penalty will be applied.

5.   College and Higher Education Costs

If you have children or grandchildren entering college, you can tap your traditional IRA without penalty in order to pay for qualified educational expenses. The school in question must be an accredited university or vocational school eligible to receive federal funding. The withdrawn money must be spent on tuition, room and board, fees, or equipment costs (i.e., books and lab materials). If you plan on going back to school yourself, you can make a withdrawal against your own IRA to pay for your own expenses too.

6.   Substantially Equal Periodic Payments (SEPP)

We saved the trickiest one for last. A SEPP plan allows an IRA account holder to make annual withdrawals for income purposes provided the same method for distribution is used each year. You must stick with the SEPP plan for five years or until you turn 59 ½ and qualify for normal distributions.

How are SEPP plan distributions calculated? The IRS has three acceptable methods:

  • Amortization – Calculated using the IRS’s life expectancy tables
  • Annuitization – Calculated based on account holder’s age and a specific interest rate, much like an annuity.
  • Required Minimum Distribution – Calculated based on account holder’s age and divided by the annual account balance.

A SEPP plan is like a speeding train. Once you start it, you can’t stop it until the end of the line. A SEPP plan will lock you into a specific payment schedule for at least five years, so consider the pros and cons of this method before tapping your IRA.

Speak With a Financial Advisor

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

Disclosure

The options voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.