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Exceptions to the Early Withdrawal Penalty on an IRA or 401(k)

Submitted by Leo McKittrick on Fri, 10/26/2012 - 11:16am
McKittrick & Associates do not provide legal or tax advice. We want you to have the necessary information to make an informed decision. We strongly suggest that you seek professional advice.

Many IRA and 401(k) owners are aware they can be hit hard with a federal penalty fee if they withdraw money early. Fortunately, there are ways to avoid this fee if an emergency or other qualifying circumstance occurs. Before we begin, let me say that even with these allowances, you should make every effort to avoid taking money out of your retirement account(s) early, especially if you are young. By withdrawing your money, you are losing decades of tax-free compounding which can cost you hundreds of thousands of dollars by the time you retire.

1. Permanent disability of IRA or 401(k) owner
Money can be withdrawn without penalty in the event the IRA or 401(k) holder becomes permanently disabled.

2. Death of IRA or 401(k) owner
If you pass on before you're 59 1/2 years old, your heir(s) or estate won't be hit with the 10% early withdrawal fee.

3. Withdrawals are used to pay non-reimbursed medical expenses
In the event of serious illness or injury that requires prolonged or expensive medical treatment, the IRS will waive the early withdrawal fee on the condition that the expenses you paid with the IRA money were for expenses in excess of 7.5% of your adjusted gross income. In other words, you need to pay 7.5% of your Adjusted Gross Income for the medical bills with your personal funds or credit cards!! Talk with your tax professional.

4. Withdrawals used to help pay for first-time home purchase
Despite a lifetime limit of $10,000, this exemption can make it much easier for an IRA owner to buy a house. This rule DOES NOT apply to the 401(k).

5. Higher education costs
College can be expensive. Thankfully, certain higher education costs for you, your spouse, children or grandchildren can be withdrawn penalty-free. You will probably still owe federal income tax on the amount withdrawn. For more information, read the Internal Revenue Service Publication 970 Tax Benefits for Education Expenses.

6. Money is used to payback taxes to the IRS after a levy has been placed against the IRA
This is not an exemption that you want to qualify for, but it may save you money if you find yourself in an unfortunate position with the IRS. This exception applies only to the IRA having an IRS levy placed against it, NOT an IRS levy against you personally or a business that you owe.

7. Withdrawals used to pay medical insurance premiums
Out of a job? You won't be penalized for using retirement money to pay your medical insurance as long as you have been on unemployment for longer than twelve weeks. You may owe federal income tax on the amount withdrawn.

8. Made on or after the day the IRA or 401(k) owner turns 59 1/2
Once you have reached the qualifying age of 59 ½ years old plus one day to be on the safe side, you can make penalty-free withdrawals.

There is one catch to these qualifying exemptions; the holder of an IRA is subject to a five year waiting period (measured in tax, not calendar years). An investor could not, for example, deposit $3,000 in their IRA this year and withdrawal it next year penalty-free even if it would otherwise qualify as an exemption. For example, you deposited $3,000 into your IRA for your 2011 IRA contribution on July 1, 2011. You cannot withdraw that $3,000 until January 1, 2017.