Penalty Exceptions for “Early” Withdrawal Distributions from Your IRA

June 11, 2009

With investors forced to dip into IRA accounts early and face 10% penalties, it is important to find out in advance if you might qualify for an exemption.

Distributions taken from a Traditional IRA before the IRA holder reaches age 59 are called early distributions. The amount included as income is subject to a 10% penalty under the federal tax code. However, there are a few exceptions where the 10% penalty does not apply. With many investors forced to dip into retirement savings, it is important to find out in advance if you might qualify for an exemption.

Below are a few examples to illustrate when individuals are exempt from paying the 10% early distribution penalty:

Beneficiary: A distribution made to a beneficiary or to the IRA holder’s estate due to the IRA holder’s death is not subject to this penalty.

Disability: A distribution made due to disability is not subject to this penalty. (Someone will not considered disabled unless he or she furnishes proof of the disability in such form and manner as may be required.)

Substantially Equal Payments: A scheduled series of substantially equal periodic payments is not subject to this penalty. This special exception is subject to many restrictions. Investors should consult their advisor, CPA, or attorney for more information about their specific circumstances.

Medical Expenses: A distribution made to pay for medical expenses that exceeds 7.5% of gross income is not subject to this penalty.

Health Insurance: An IRA distribution can be taken without penalty by an unemployed individual to pay for health insurance if he or she receives unemployment compensation for 12 consecutive weeks. The amount of the qualified distribution may not exceed the amount paid for insurance protection.

Qualified Higher Education Expenses: An IRA distribution is not subject to this penalty if taken to pay for qualified higher education expenses of the IRA holder, the IRA holder’s spouse, or any child or grandchild of the IRA holder or the IRA holder’s spouse.

First-Time Home Buyer Expenses: This penalty does not apply when an IRA distribution is taken from an IRA to pay for certain first-time home purchase expenses (subject to specific dollar limitations; please check with your advisor).

Conversions (Direct or Indirect): An IRA distribution from a traditional IRA that is properly converted to a Roth IRA is not subject to this penalty. IRS Levies Effective for distributions after December 31, 1999, a distribution that is made as a result of an IRS tax levy, is not subject to this penalty.

Qualified Reservist Distribution: An IRA distribution taken by a qualified U.S. military reservist (including National Guardsmen) who is called to active duty after September 11, 2001, is not subject to this penalty.

Rollover: A proper direct rollover, indirect rollover, or transfer is not subject to this penalty.

Non-deductibles: The portion of a distribution representing a return of nondeductible IRA contributions is not subject to this penalty.

T.J. Valenzuela is with Trust Administration Services, a leading personal management provider of self-directed IRA retirement accounts, retirement planning services, and custody accounts.