What Are the Exceptions to the 10% Early Withdrawal Penalty?
Money can be easily moved around, and there may be legitimate reasons to withdraw early from retirement accounts before age 59 1/2. Unfortunately, such withdrawals incur an early withdrawal penalty of 10% in addition to any income taxes owing.
However, there are exceptions to this general rule and this article will discuss some of the more commonly occurring ones: 1. Medical expenses
1. Death of the Participant/IRA Owner
An amount withdrawn from a qualified retirement plan or an IRA due to death does not incur the 10% early withdrawal penalty; this exception does not apply in cases of inheritance wherein the designated beneficiary is younger than age 59 1/2.
Benefits paid as the result of a federally declared disaster are exempt from the 10% penalty, including distributions from both IRAs and employer-sponsored plans.
Distributions used to purchase a first home are exempt from the 10% penalty, including amounts used by you, your spouse, children or grandchildren. You can also withdraw funds from an IRA to cover unreimbursed medical expenses that exceed 10% of adjusted gross income.
2. Total and Permanent Disability
When withdrawing funds from a retirement account due to total and permanent disability, the 10% early withdrawal penalty does not apply. You must however demonstrate that your disability prevents engaging in substantial gainful activity.
Example: You may make a penalty-free withdrawal of your IRA funds if unreimbursed medical expenses that exceed 10% of your adjusted gross income exceed $10 000 during a year that you make the distribution. It does not need to be tied back directly with specific expenses; simply withdrawing all or some amount may do.
Avoiding the 10% penalty can also be done through substantially equal periodic payments (SEPPs) from your IRA or employer-sponsored plan, but these must continue until either age 59 1/2 is reached or five years have lapsed, whichever comes first.
When the COVID-19 pandemic struck, the CARES Act allowed retirement account distributions without incurring the 10% penalty if used to cover medical expenses (to the extent they exceeded 7.5% of adjusted gross income), birth or adoption expenses or unemployment compensation payouts for 12 weeks or more. Furthermore, under this exception rule if you lost your job and received unemployment compensation payments for more than 12 weeks you could withdraw funds without penalty to cover health insurance premiums for yourself, spouse and any dependents.
Cashing out your 401(k) early may seem attractive in times of uncertainty or shortfall, but remember that you will still owe regular income taxes and the 10% penalty. Furthermore, by locking in losses early you’re also inhibiting long-term savings potential.
Redeployment refers to the practice of shifting employees between different roles within an organization in order to prevent redundancy, often during times of change or transformation when there are surplus workers remaining. This may happen as part of restructuring efforts where it would otherwise result in job cuts for some workers.
This practice can reduce time-to-fill times, internal costs and activity levels as well as save on external recruitment fees. Furthermore, it keeps contractor skills current so they can be quickly engaged for future projects.
Redeployment jobs should generally be accepted unless an employee can demonstrate that their current role is unsuitable or they would need additional training to perform them without reasonable adaptations. Rejecting redeployments could jeopardise an employee’s right to redundancy pay.
5. Permanent Disability
If you become completely and permanently disabled and can no longer engage in substantial gainful activity, the 10% early withdrawal penalty can be waived from a retirement account. To take advantage of this benefit, a doctor must produce a permanent and stationary (P&S) report. This report serves similar functions to workers’ compensation reports in that it details your unique disability situation.
There are other exemptions to the 10% early withdrawal penalty that apply equally to both QRPs and IRAs, including attainment of age 59 1/2, death, substantially equal periodic payments, IRS levies, educational expenses, first-time homebuyer costs and health insurance premiums after unemployment; additionally, the CARES Act of 2020 waives it in cases related to COVID-19 distributions.
Categorised in: Blog