It is widely known that withdrawals from tax advantaged accounts (401(k)s, IRAs, etc.) before age 59.5 are subject to a 10% early withdrawal penalty. This penalty is in place to discourage individuals from using funds before retirement. But there are a few exceptions to this penalty.
Here’s a list of exceptions to the 10% early withdrawal penalty:
·Death: Applies to both qualified plans and IRAs
· Attainment of age 59.5: Applies to both qualified plans and IRAs
· Disability: Applies to both qualified plans and IRAs
· Substantially equal periodic payments: Applies to both qualified plans and IRAs
· Medical expenses that exceed 7.5% of AGI: Applies to both qualified plans and IRAs
· $5,000 per taxpayer for birth or legal adoption: Applies to both qualified plans and IRAs
· Qualified Domestic Relations Order (QDRO): Applies to qualified plans ONLY
· Qualified public safety employee who separates from service after age 50: Applies to qualified plans ONLY
· Attainment of age 55 and separation from service: Applies to qualified plans ONLY
· Higher education expenses: Applies to IRAs ONLY
· First time home purchase of up to $10,000: Applies to IRAs ONLY
· Payment of health insurance premiums by unemployed: Applies to IRAs ONLY
Additional Information on Substantially Equal Periodic Payments:
There are three ways the payments can be made:
1. Require Minimum Distribution method: Distributions are calculated in the same manner as RMDs.
2. Fixed amortization method: Distributions are calculated over the life expectancy of the owner if single, the joint life expectancy if married, along with a reasonable interest rate. This creates a series of payments that remain the same.
3. Fixed annuitization method: Distributions are calculated by dividing the account balance by an annuity factor using a reasonable interest rate and mortality table. The payment does not change in future years.
The payment calculated under one of the methods above must continue exactly as calculated until the later of age 59.5 or five years from the date of the first payment. If payments change in any way, it will be considered that the individual made a distribution of the full account balance in the first year that the periodic payments started.
Part of the reason why we preach tax diversification is to avoid having all funds “locked” up in retirement accounts. Before moving forward with any early withdrawals, the application, specifics, and tax ramifications of these exceptions must be considered. We recommend consulting with your advisor and tax preparer before making any decisions.
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