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Early retirement payouts 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that individuals are properly reporting distributions from IRAs and qualified employer plans, such as 401(k)s, that are withdrawn before age 59½.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% penalty hits most pre-age-59½ taxable payouts. This additional excise tax on early distributions is in addition to any regular income tax that is due.
But there are many important exceptions. Some apply to IRAs and 401(k)s. Others pertain to only one or the other. Some are newer, added by Congress in the SECURE Act in Dec. 2019, and the SECURE 2.0 Act late last year. We’ll review some common exceptions here.
IRA and 401(k) Exceptions
Early withdrawals from IRAs and 401(k)s by disaster victims are penalty-free on up to $22,000 per disaster. There is a time limit: The payout must generally be taken within 179 days of the date the disaster is declared. The deadline was June 27, 2023, for federally declared disasters that arose on Jan. 26, 2021, through Dec. 28, 2022.
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 taxpayer, 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.
Taking substantially equal payments from an IRA or 401(k) is a key exception. Distributions must 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.
Among other 401(k) and IRA exceptions to the 10% penalty: Terminal illness, permanent disability or death of account owner, some beneficiaries of deceased owners, and IRS levy on retirement funds. People having a baby or adopting can take up to $5,000. Starting in 2024, two more exceptions go into effect. First, victims of domestic abuse can take up to $10,000 penalty-free. Second, account owners can withdraw up to $1,000 penalty-free for emergencies.
IRA Exceptions Only
Early payouts from IRAs to help “first-time” home buyers are penalty-free. IRA owners who didn’t own a home in the prior two years can take out up to $10,000 to buy or build their main home or one for a spouse, kid, grandkid, parent or grandparent. The funds must be spent within 120 days of receiving the distribution.
Ditto for the cost of higher education…college tuition, computers, books, and room and board for students enrolled at least half-time. There’s no dollar cap. To qualify for the exception, the early distribution must cover education costs for the IRA owner, spouse, child or grandkid that are paid in the year of the withdrawal.
The unemployed can use IRA funds to buy health insurance in some cases. Payees must be on unemployment for 12 weeks. Self-employed individuals also qualify.
Early distributions from 401(k)s for the above three reasons don’t get relief.
401(k) Exceptions Only
There’s relief for workers who leave their jobs in the year they turn 55, or later. Their early 401(k) withdrawals escape penalties. The age is 50 for public safety officers.
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. The QDRO exception doesn’t apply to IRA funds paid to an ex-spouse in a divorce.
This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe.
