Exceptions to the 10% Early Withdrawal Penalty
Financial difficulties often require individuals to withdraw funds from their retirement accounts early; however, early withdrawal can result in penalties of 10% and taxation at ordinary income rates.
However, the IRS offers exceptions to this penalty and in this article will cover some of them – such as withdrawals from IRAs and employer-sponsored retirement plans such as 401(k).
Public Safety Employees
Typically, withdrawals made prior to age 59 1/2 from qualified retirement plans incur an extra 10% tax (not including IRAs). However, the 2022 Secure Act 2.0 made one important exception: federal public safety employees can now access their Thrift Savings Plan accounts without incurring an early withdrawal penalty when leaving service during or after reaching age 55.
This exception applies to LEOs, CBPOs, FFs, and ATCs who have at least 25 years of federal service and were employed in a position eligible for TSP on either their TSP separation date or P employment code date of departure from federal service. Each agency should identify these public safety employees; TSP doesn’t hold that information.
The payroll office should submit this information to TSP in an employee’s EDR and use it to flag 1099-Rs so that an additional penalty does not apply for distributions.
Educators
Congress recognizes the dedication of teachers and school employees by permitting them to withdraw without penalty from their 403(b) plans. Withdrawals must be used solely to pay qualified education expenses for either themselves, their spouse, children, grandchildren or future grandchildren including tuition, fees, books or necessary equipment purchased within one year after distribution of funds.
This exemption does not cover student loan repayments; therefore educators should explore other methods to repay them. Furthermore, this exception does not apply to withdrawals from an inherited IRA treated as belonging to either of the spouses who inherit it.
Meleca Vulic, a teacher, received a lump sum distribution from her company retirement plan before the age of 59 1/2 in 2000 under financial hardship justification and anticipated being free from paying the 10% penalty tax. Unfortunately she lost in Tax Court and became responsible for an amount totalling $8,117 plus 20% accuracy-related penalties under Section 6662.
Separation from Service at Age 55 or Older
Typically, any withdrawal from a workplace retirement account prior to age 59 1/2 incurs a 10% early withdrawal penalty (in addition to income taxes). But if you leave Target before or shortly before reaching 55th birthday or are laid off around this age, then access to money in their 401(k) or 403(b) plan may not incur this fee.
The taxability of distributions depends on plan rules, which may be complex. There are ways that are universally accessible to bypass penalties: Substantially Equal Period Payments (SEPPs), annual annuity-like withdrawals that must be taken for at least five years or until reaching age 59 1/2 (whichever comes first).
But according to Tax Court ruling, in order to take advantage of this exception before age 55 you must conduct your separation “bona fide”. When considering this option for yourself it is wise to carefully assess its long-term financial repercussions before making your decision.
Terminal Illness
Congress expanded the circumstances under which early withdrawal penalties do not apply from retirement and IRA accounts several years ago, expanding them even further under SECURE Act 2.0 of 2022 by permitting distributions to terminally ill participants and owners of these accounts.
Physician certification of illness or condition that reasonably expects death within 84 months must occur for distributions to take effect, though any funds given back into an account or plan can be recontributed within three years.
However, according to the Notice, plan sponsors’ decisions to permit Tax-Induced Distributions are voluntary and do not affect other restrictions that exist under their Plan (such as in-service distributions and hardship distributions). Therefore, participants must satisfy other requirements in order to avoid the 10% early withdrawal penalty; certification from a physician must be provided to both plan administrators and participants and keep a copy for their tax records.
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