Retirement Savings – Exceptions to the 10% Early Withdrawal Penalty
Savers who withdraw funds before age 59 1/2 typically incur an additional 10% tax penalty on top of regular income taxes.
There are certain circumstances under which savers do not incur the early distribution penalty for both individual retirement accounts (IRAs) and workplace retirement plans such as 401(k). These exceptions apply both to IRAs and workplace plans like 401(k).
First-time homebuyer
The SECURE 2.0 Act, which passed as part of an omnibus spending bill in December 2022, added several exceptions to the 10% early withdrawal penalty tax for traditional IRAs and employer-sponsored retirement accounts (such as 401(k)s or 403(b) plans) held within traditional IRAs and employer sponsored retirement accounts like 401(k)s or 403(b). These 72(t) exceptions make buying your first home more affordable.
First-time homebuyers may qualify for cash grants and reduced mortgage rates from state and local programs; while federal programs provide loans without PMI or down payments as assistance for first-time buyers.
Fannie Mae offers the HomePath program as another means for homebuyers looking for foreclosed properties, requiring just 3% down. Homebuyers must enroll and successfully complete a Homebuyer Education class prior to purchasing such property, though. Furthermore, some properties must meet specific conditions before being considered suitable as primary residence.
Education expenses
Avoiding the 10% penalty by withdrawing funds from retirement savings for education expenses can help to circumvent it, provided that withdrawals meet certain rules. First, the distribution must go toward qualifying higher education expenses of either the IRA owner, spouse or children (nieces, nephews and cousins are ineligible) such as tuition, fees, books, supplies equipment room and board; special-needs services as well as participation in government administered student aid programs also qualify as qualifying costs.
Additionally, your distribution must come in the form of substantially equal periodic payments that extend over your life expectancy. Otherwise, the 10% penalty and regular federal income taxes apply; this rule also applies to 529 accounts nonqualified withdrawals. Under Secure 2.0 law there may be some limited exceptions that allow penalty-free withdrawals such as mortgage refinancing expenses; these do not extend beyond emergency expenses however.
Medical expenses
When under 59 1/2 and needing to tap your retirement account, there may be exceptions that permit withdrawal without incurring the 10% penalty. Document all expenses properly and use any withdrawals accordingly.
As an example, you can avoid paying the penalty if you use an IRA withdrawal to cover unreimbursed medical expenses that exceed 7.5% of your adjusted gross income in the year of withdrawal. No need to link your withdrawal back to specific expenses but they must be paid in the same year of distribution.
Congress may add more exceptions with their Secure 2.0 bill; but even if you qualify, income taxes still must be paid on any money withdrawn early from retirement savings accounts. It is therefore wise to consult a financial professional prior to withdrawing early.
Separation from service
An exception called separation from service may allow you to avoid paying the 10% withdrawal penalty on Target-sponsored retirement plans that offer it, provided they include such a provision. Before opting to utilize this rule, however, be sure to fully understand their rules as well as your retirement expenses before making this decision.
The IRS defines separation from service as any act that permanently disconnects an employee from his or her employment with a company, rather than just changing legal status. To qualify for favorable tax treatment, distributions must be based on either genuine separation from service or attainment of age 59 1/2.
Some exceptions apply to both qualified retirement plans (QRPs) and individual retirement accounts (IRAs); others are specific to either QRPs or IRAs. Examples include:
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