There is a lot of confusion about the 10% penalty that the IRS imposes on early benefits from retirement plans. Most people know that this penalty exists for those who take out deferred retirement funds before age 59, although many don’t realize it’s on top of your current tax rate.
Many people have also heard that there are exceptions to the 10% fine, although they almost never fully understand what those exceptions are and when they are applied.
Today, we’ll explain when and where these exemptions to early withdrawal penalties are applied by splitting distributions into three different groups: traditional IRAs, retirement plans other than IRAs, and finally a group that includes both IRAs. and retirement plans.
10% Penalty Exceptions – For IRAs Only
The exceptions to the penalty for traditional IRAs are the ones most people have heard of, but they often assume they apply to every type of plan, which isn’t necessarily the case. The following exceptions are strictly limited to traditional IRAs. These exceptions do not apply to 401(k)s, 403(b)s or other tax-deferred retirement plans:
- A first home purchase – up to $10,000 can be withdrawn for a down payment by a first home buyer (and if your spouse also has an IRA and qualifies as a first home buyer, they can withdraw up to $10,000 toward the purchase as well).
- Buying health insurance – if you lost your job and received unemployment for at least 12 consecutive weeks.
- Pay for higher education expenses – for yourself, a spouse, children or grandchildren.
Exceptions to the 10% penalty – for 401(k)s and similar pension plans
Qualified retirement plans, such as 401(k)s, 403(b)s, profit-sharing plans, and Keogh plans, offer a few more options for avoiding the 10% early retirement penalty than IRAs, including:
- Distribution of the assets of the pension account in the event of a separation under a Qualified Domestic Relations Order (QDRO).
- Distributions from 457(b) government plans, excluding benefits attributable to rollovers from another type of plan or IRA.
- Over-50s benefits for public safety officers who retire from the service.
- Benefits for over-55s in other areas who retire from service.
- Benefits from “phased” federal plans. With a staged retirement option, employees at or near retirement age can reduce their working hours to part-time, receive benefits, and continue to earn extra money.
Exceptions Applicable to BOTH IRAs and 401(k)s
Some exceptions may apply to both IRAs and retirement plans, and these include:
- Qualified Reservists – Called up on active duty for a minimum of 179 days, or indefinitely because you are a reserve member.
- Disability – must meet the IRS definition of total and permanent disability and have documentation from a physician.
- Death of the account owner.
- IRS Taxation – You wouldn’t owe a penalty if the IRS draws on your account to collect unpaid federal taxes. However, if you make an early withdrawal to pay a tax bill yourself, the exception does not apply and you will be subject to the 10% penalty.
- Medical expenses (to the extent that they exceed 10% of your adjusted gross income).
- Adoption or birth of a child – up to $5,000 in withdrawals can be penalty free in the first year.
- Nearly equal payments (also known as the 72