Not All Early Retirement Account Withdrawals Come with a Penalty

Early retirement distributions are an IRS red flag. The agency wants to make sure that individuals are properly reporting distributions from IRAs and qualified employer plans, such as 401(k)s, that are withdrawn before age 59½. An IRS review from a number of years ago found that 40% of people scrutinized made mistakes, with most of those errors coming from taxpayers who didn't qualify for one of the numerous exceptions to the additional excise tax on early distributions.

A 10% excise tax hits most pre-age-59 ½ withdrawals from IRAs, 401(k)s and certain other retirement accounts. This penalty on early distributions is in addition to any regular income tax that is due on the payout. A Department of Treasury inspectors' report found that 2.8 million taxpayers who received early distributions totaling $12.9 billion in 2021 didn't pay the 10% additional tax.

Fortunately, there are many exceptions to the 10% penalty on early retirement distributions. Some apply to both IRAs and 401(k)s. Others pertain to only one or the other. Some are newer, added by Congress in the SECURE Act in 2019 and the SECURE 2.0 Act in 2022. Others have been around for many years.

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We'll review the exceptions here:

Substantially equal periodic payments

Taking substantially equal periodic payments from an IRA or 401(k) is a key exception to the 10% penalty on pre-59½ retirement withdrawals. Distributions must be consistent, made at least annually, calculated based on one of three pre-approved methods and continue for the longer of five years or until the recipient hits 59½.

Withdrawals must be based on the owner's life expectancy or the joint life expectancy of the owner and named beneficiary. If you modify the annual payment amount, previous distributions taken from the account will be hit with the 10% penalty.

Medical costs

IRAs and 401(k)s can be utilized to pay big medical expenses without penalty. The money must be used for medical costs of the account owner, spouse or dependent.

The funds must cover costs paid in the year of the withdrawal. And only the amount of unreimbursed medical expenses that exceeds 7.5% of adjusted gross income counts.

'First-time' homebuyers

IRA owners who didn't own a home in the prior two years can take out up to $10,000 to buy or build a main home or one for a spouse, kid, grandkid, parent or grandparent without paying the 10% penalty.

Higher education

You can take pre-59½ IRA distributions penalty-free to pay for college tuition, computers, books and room and board for students enrolled in school at least half time. There is no dollar cap.

The distribution must cover education costs for the IRA owner, spouse, child or grandkid that are paid in the year of the withdrawal.

Workers who retire at 55 or older

There's relief for workers who leave their jobs in the year they turn 55 or later. Their early 401(k) withdrawals taken before 59½ escape the 10% penalty. The minimum age is 50 for public safety employees.

Divorce

Paying 401(k) funds early to an ex-spouse can avoid penalties, if done right. Use of a qualified domestic relations order is needed to escape the 10% penalty. This exception doesn't apply to IRA funds paid to an ex-spouse in a divorce.

Terminal illness

Pre-59 ½ distributions to terminally ill 401(k) or IRA participants escape the 10% fine. An individual is terminally ill if a physician provides certification of the person's illness or other physical condition that is reasonably expected to result in death within 84 months of the certification date.

Family or personal emergency

There is no general hardship exception for the 10% tax on early retirement payouts, but there is limited relief for early withdrawals from IRAs and 401(k)s of up to $1,000 to cover personal or family emergency expenses.

The emergency distribution must be for unforeseeable or immediate financial needs relating to the account owner's necessary personal or family emergency expenses.

Other exceptions

There are many other exceptions to the 10% penalty on early distributions. The following apply to both IRAs and 401(k)s: Victims of federally declared disasters, subject to a cap of $22,000 per disaster; IRS levy on retirement funds; birth or adoption of a child, subject to a $5,000 cap; up to $10,500 for domestic abuse victims; certain military reservists called to active duty, and death or permanent disability of the account owner.

Some exceptions that apply only to 401(k)s: Distributions from a pension-linked emergency savings account; certain withdrawals from workplace retirement plans with automatic enrollment features; starting in 2026, up to $2,500 in early distributions from 401(k)s can be used penalty-free to pay long-term care premiums.

There's also an exception to the 10% penalty on early withdrawals for unemployed IRA owners who use the distributions to pay for health insurance while unemployed. The IRA owner must be unemployed for at least 12 consecutive weeks and must receive unemployment compensation in the year of the distribution or the subsequent year.

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Note: This item first appeared in Kiplinger Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.

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