Can I Withdraw Funds From My Individual Retirement Account (IRA) Early?

 

Individual retirement accounts (IRAs) are a fantastic way to plan and save for the future.  The money that is invested into it can grow on tax-deferred status until you retire.  If you opted for a traditional IRA, the money that you contribute may be tax deductible in the year it was made (although the distributions are fully taxable).  If you opted for a Roth IRA, you pay taxes on the amounts that are contributed, but the withdrawals are tax-free after reaching retirement age.

However, IRAs do have strings attached to accessing the funds therein.  It is not freely available for access like a normal bank account.  If a taxpayer takes an early distribution from an IRA account (whether it is a traditional IRA, Roth IRA, SEP IRA or SIMPLE IRA) before reaching age 59 ½, then that transaction will be subject to an additional 10% tax penalty.  26 U.S. §72(t)(1).  This penalty is in addition to any regular income taxes that the transaction would normally be subject to.

However, the Internal Revenue Code provides various exceptions for withdrawing IRA funds without a penalty.  Accessing this money may be absolutely necessary for your current financial situation.  Most tax advisors would recommend that reaching into your IRA should be a last resort, but sometimes it can’t be avoided.

Here are the scenarios where IRA funds may be distributed without incurring the early withdrawal penalty:

• PAYMENT MADE TO BENEFICIARY OR ESTATE: There is no early withdrawal penalty if the distribution is made to a beneficiary (or to the estate of the taxpayer) on or after the death of the taxpayer. 26 U.S. §72(t)(2)(A)(ii).

• PAYMENT ATTRIBUTABLE TO DISABILITY: There is no early withdrawal penalty if payments are attributable to the taxpayer’s being disabled as defined under the Internal Revenue Code. 26 U.S. §72(t)(2)(A)(iii).  “[A]n individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”  26 U.S. §72(m)(7).  The taxpayer may have to be prepared to demonstrate proof of his or her disability to the IRS.

• PAYMENT IS PART OF SERIES OF SUBSTANTIALLY EQUAL PERIODIC PAYMENTS: There is no early withdrawal penalty if payments are “part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and his or her designated beneficiary.” 26 U.S. §72(t)(2)(A)(iv).

• RETIREMENT FROM EMPLOYER AT AGE 55: There is no early withdrawal penalty if the employee separates from service after attaining age 55 and begins to draw distributions. 26 U.S. §72(t)(2)(A)(v).

• PAYMENTS ARE QUALIFIED DIVIDENDS: There is no early withdrawal penalty if the dividends are paid with respect to stock of a corporation held by the mutual fund or IRA account. However, the dividend is still considered taxable income for the purposes of income taxation.  26 U.S. §72(t)(2)(A)(vi).

• LEVY BY THE INTERNAL REVENUE SERVICE: There is no early withdrawal penalty if the Internal Revenue Service seizes funds as part of a levy for a past-due tax obligation. 26 U.S. §72(t)(2)(A)(vii).

• MEDICAL EXPENSES: There is no early withdrawal penalty for distributions used to pay for medical expenses NOT reimbursed by health insurance that EXCEED 10% of the taxpayer’s gross income. 26 U.S. §72(t)(2)(B).  Although the medical expenses deduction is available to taxpayers who itemize on Schedule A, the early withdrawal penalty is waived even if the taxpayer does not itemize provided the distribution was consistent with this rule.

• PAYMENTS PURSUANT TO QUALIFIED DOMESTIC RELATIONS ORDERS (QDROs): There is no early withdrawal penalty for any payments made pursuant to a QDRO from a state court (e.g. division of property consistent with judgment of divorce). 26 U.S. §72(t)(2)(C).
  

• DISTRIBUTIONS TO UNEMPLOYED INDIVIDUALS FOR HEALTH INSURANCE PREMIUMS: There is no early withdrawal penalty for individuals who have received unemployment compensation for 12 consecutive weeks under any federal or state compensation plan and the distributions do not exceed the amount paid during the tax year for health insurance covering the taxpayer, his or her spouse and dependents. 26 U.S. §72(t)(2)(D)(i).  The distribution is subject to early distribution penalties if the taxpayer is reemployed for at least 60 days at the time the distribution is made.  26 U.S. §72(t)(2)(D)(ii).  A self-employed individual can receive distributions without penalty to pay for health insurance premiums if he or she would have received unemployment compensation but for the fact that the individual was self-employed.  26 U.S. §72(t)(2)(D)(iii).
  

• DISTRIBUTIONS FOR HIGHER EDUCATION EXPENSES: There is no early withdrawal penalty to the extent that distributions do not exceed the qualified higher education expenses of the taxpayer for the tax year.  26 U.S. §72(t)(2)(E).  “Qualified higher education expenses” means the costs of tuition, books, fees etc. to a post-secondary school (e.g. college, university) attributable to the taxpayer, his or her spouse, child or grandchild, but reduced by any scholarships, grants or other benefits received.  26 U.S. §72(t)(7).  This exception does not apply if the taxpayer qualifies for another distribution exception.

• DISTRIBUTIONS FOR FIRST-TIME HOMEBUYERS: There is no early withdrawal penalty to the extent that distributions are qualified first-time homebuyer distributions.  26 U.S. §72(t)(2)(F).  “Qualified first-time homebuyer distribution” means any payment or distribution used within 120 days of being received to pay acquisition costs with respect to a principal residence who is a first-time homebuyer (which includes the taxpayer, his or her spouse, or any descendant or ancestor of either).  26 U.S. §72(t)(8)(A).  However, the total amount of IRA distributions for qualified first-time homebuyer expenses is limited to $10,000.00.  26 U.S. §72(t)(8)(B).  Qualified acquisition costs include the cost of acquiring, constructing or reconstructing a residence and covers “any usual or reasonable settlement, financing, or other closing costs”.  26 U.S. §72(t)(8)(C).  “First-time homebuyer” means any individual (or his or her spouse if married) that had no present ownership interest in a principal residence during the preceding 2-year period ending on the date of acquisition of the new principal dwelling.  26 U.S. §72(t)(8)(D).  This exception does not apply if the taxpayer qualifies for another distribution exception.

• DISTRIBUTIONS TO INDIVIDUALS CALLED TO ACTIVE DUTY: There is no early withdrawal penalty for any “qualified reservist distributions” made to individuals who was a member of a reserve component called to active duty for 180 days or more (or for an indefinite period) and distributions were made after the date of receiving orders but before the close of the active duty period.  26 U.S. §72(t)(2)(G)(iii).  The reservist may repay these amounts distributed to the IRA at any time during the 2-year period immediately following the last day of active duty, even if these amounts exceed the normal contribution limits for the tax year.  26 U.S. §72(t)(2)(G)(ii).
  

• DISTRIBUTIONS IN CASE OF BIRTH OR ADOPTION: There is no early withdrawal penalty for any “qualified birth or adoption distribution” made during the 1 year period beginning on the date that a child of the taxpayer is born or on which the legal adoption of an eligible adoptee is finalized. 26 U.S. §72(t)(2)(H)(iii)(I).  An “eligible adoptee” is any individual under 18 years old or an individual who is physically or mentally incapable of self-support.  26 U.S. §72(t)(2)(H)(iii)(II).  The total distributions attributable to qualified birth or adoption expenses is limited to $5,000.00.  26 U.S. §72(t)(2)(H)(ii).  The taxpayer may repay these amounts distributed to the IRA account even if these amounts exceed the normal contribution limits for the tax year.

• DISTRIBUTION SUBJECT TO LOAN AGREEMENT: There is no early withdrawal penalty for any distribution made pursuant to a loan agreement with the financial institution holding the IRA. 26 U.S. §72(p).  The loan is subject to certain statutory limits on the amount that may be borrowed and the repayment period cannot exceed FIVE YEARS.

• ROLLOVER CONTRIBUTION TO ANOTHER IRA ACCOUNT: There is no early withdrawal penalty for any distribution or payment if the entire amount received is paid into another IRA account or annuity (other than an endowment contract) within 60 days after the day the taxpayer receives the funds. 26 U.S. §408(d)(3).  If the 60th day deadline is missed, the IRS may waive the penalty if a hardship can be shown.  26 U.S. §408(d)(3)(I).  A taxpayer is even permitted to rollover over funds from a traditional IRA to a Roth IRA without an early distribution penalty, but the amount distributed will have to be included in gross income that can be paid ratably over the next two-year period.  26 U.S. §408A(d)(3).

• DISTRIBUTIONS TO CORRECT EXCESSIVE CONTRIBUTIONS: There is no early withdrawal penalty for distributions made during the tax year to withdraw excessive contributions to the IRA account.  26 U.S. §408A(d)(2)(C).

Congress passed and President Trump signed into law the Coronavirus Aid, Relief and Economic Security (CARES) Act on March 27, 2020 to provide much needed support for Americans during the COVID-19 crisis.  One of the financial relief aspects of the Act is waiving any early distribution penalty for “coronavirus-related” payments from retirement account.  A “coronavirus-related distribution” means ALL of the following:

• A distribution from an eligible retirement account made on or after January 1, 2020 and before December 31, 2020. CARES Sec. 2202(a)(4)(A)(i).

• To an individual who is diagnosed with COVID-19, or whose spouse or dependent is diagnosed with COVID-19, or “who experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary of the Treasury.” CARES 2202(a)(4)(A)(ii).

The amount of “coronavirus-related” funds that may be distributed is limited to $100,000.00.”  CARES Sec. 2202(a)(2)(A).  In addition, any individual who receives a coronavirus-related distribution may, at any time during the 3-year period beginning on the day after the date on which such distribution was received, make contributions to repay the IRA account without triggering an excessive contribution penalty.  CARES Sec. 2202(a)(3)(A).

The rules for IRA distributions are complex and subject to additional IRS rules and regulations.  Before taking an early distribution, you should consult with a skilled tax professional to see if your IRA payment will meet an approved exception under your unique circumstances.  If you have questions about IRAs or any other aspect of federal taxation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.