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How to Avoid the Penalty for Early Withdrawals From Your IRA

Tapping your money early has lots of traps, but they can be avoided.

Q. I need to take money out of my IRA, but I’m not 59½. Can I avoid the 10% penalty for early withdrawals?

Yes, there are several ways, depending on how much money you need and what you need it for.

The law waives the penalty if you arrange to take out “substantially equal periodic payments,” or SEPPs, based on your life expectancy. You must take the withdrawals for five years or until you turn 59½, whichever comes later. For example, if you’re 50, you’ll have to withdraw a specific amount for at least nine and a half years; if you’re 58, you’ll have to take withdrawals until you’re 63. If your IRA is large enough that such staggered withdrawals will meet your financial need, then taking SEPPs to dodge the penalty might make sense.

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Under this “72(t)” strategy, named for a section of the tax code, the IRS permits three methods of deter­mining your annual payouts. The required minimum distribution option calculates withdrawals based on your life expectancy and your account balance at the end of the previous year. The amount of the payment is recalculated every year, so it will fluctuate depending on the value of your IRA. The other two methods, fixed amortization and fixed annuitization, use slightly different formulas and require you to withdraw the same amount every year.

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Payments you get under the RMD calculation are usually lower than with the other two methods. For example, a 50-year-old man with a $100,000 IRA balance who opts for the RMD formula would receive $2,923 the first year. If he uses the amortization option, he’d receive $3,904; with the annuity method, $3,889. (You can run your own calculations at http://72t.net/72t/calculator/distributions.)

Locking yourself into mandatory withdrawals for at least five years is risky. You can’t make new contributions to the IRA or take additional withdrawals during that time. If you violate any of the rules, you could still be hit with big penalties. And if you take distributions under the amortization or annuitization method and the market swoons, those forced withdrawals will exacerbate the damage before your investments have time to recover.

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If SEPPs from your IRA would be more than you need, you could split the IRA into two separate accounts and take periodic payments from just one of them, says Gil Charney, director of H&R Block’s Tax Institute. That way, you could also continue to contribute to the second IRA. Or, if you’re using the amortization or annuity method, you have a one-time option of switching to the RMD method, which could shrink the size of your withdrawals.

Other strategies. You can make penalty-free withdrawals from IRAs—without the SEPP rigmarole—for limited purposes. If you’re unemployed, withdrawals to pay for health insurance for yourself, your spouse and/or your dependents are exempt from the penalty. So are withdrawals to pay medical expenses that exceed 10% of your adjusted gross income (or, through 2016, 7.5% if you or your spouse is 65 or older). You also qualify for an exemption if you use IRA money to pay college tuition and fees for yourself, your spouse or your children. And first-time home buyers can withdraw up to $10,000 from a traditional IRA penalty-free.

No matter which strategy you use, tapping an IRA early could put a permanent dent in your retirement savings. Even when the penalty is waived, you have to pay income taxes on withdrawals. Consider other options, such as a home-equity line of credit or a loan from your 401(k) plan.

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