How to Avoid Paying Taxes on an Early IRA Withdrawal
Tax regulations surrounding Individual Retirement Accounts (IRAs) are designed to encourage saving for retirement; however, should you need to use your IRA for short-term expenses there are strategies available which can minimize income tax and penalty costs.
This article details several exceptions to the 10% early withdrawal penalty, such as:
Hardship Withdrawals
Following IRS guidelines can help you avoid penalties when withdrawing funds from an IRA for certain expenses such as medical emergencies, unreimbursed qualified medical expenses and home mortgage interest payments.
The IRS considers annual checkups, visits to a dentist or optometrist, prescription and surgeries among other expenses as qualifying medical expenses, which you can withdraw from your IRA without penalty in the year they occur.
An emergency distribution under Section 72(t) of the tax code allows you to make series of substantially equal payments over time without incurring an early withdrawal penalty of 10 percent. Usually this option is best for early retirees requiring income from their retirement accounts before reaching age 59 1/2; however it should always be discussed with a financial planner or CPA prior to making such withdrawals.
Medical Withdrawals
To avoid paying income tax or the 10% penalty when withdrawing money from any type of IRA before age 59 1/2, qualified withdrawals (those including investment earnings as well as your contributions) must meet certain requirements in order for them to qualify as qualified withdrawals. To prevent having to pay this penalty, keep a careful log of what you withdraw before age 59 1/2 in order to only withdraw contributions and not investment earnings.
Under certain conditions, you can avoid paying an early withdrawal penalty by withdrawing funds from your IRA to cover unreimbursed medical expenses that exceed 7.5% of your adjusted gross income or AGI. Or use it for higher education expenses for yourself, your spouse, or children – these withdrawals are known as substantially equal periodic payments (SEPPs) but complying with their rules is often complex and requires assistance from a tax professional.
Education Withdrawals
As soon as you withdraw money from a traditional or Roth IRA before age 59 1/2, a 10% penalty is added on top of your regular income tax rate. But there may be exceptions where this penalty does not apply – for instance, withdrawing funds to cover qualified education expenses before that age without incurring extra charges provided that certain guidelines are adhered to.
Qualified education expenses include tuition, fees, room and board and book costs associated with you or your children attending an eligible institution of higher learning. Furthermore, you can use IRA funds to cover some disability-related expenses provided that this disability is likely permanent.
Keep accurate records, such as account statements, receipts for school-related expenses and syllabi. In case the IRS conducts an audit on you, proof of expenses such as cancelled checks will be necessary as evidence.
Rollovers
If you are rolling over funds from a 403(b) or 457 plan into a traditional IRA, it’s essential that they go directly from one provider to the next in a direct rollover, in order to avoid taxes withholding and an early withdrawal penalty. According to Morris Armstrong from Armstrong Financial Strategies of Cheshire Connecticut: if an indirect rollover takes place whereby funds are distributed via check, “it must withhold 20% due to federal withholding regulations”. Any amount withheld must be deposited back into your IRA within 60 days or face taxation as well as an early withdrawal penalty.
There are various exemptions to the 10% early withdrawal penalty for IRA and 401(k) distributions. If you have specific queries, speak to a tax professional. Those not quite ready to access retirement funds could consider delaying purchases until next year in order to potentially lower taxes if they fall within a higher tax bracket this year.
Categorised in: Blog