Early Distribution of Retirement Funds - Without the Penalty
Ask most people with an IRA or qualified retirement account what happens if they withdraw funds early and they will probably tell you they'll have to pay a 10% penalty. While this may be true in most cases, there are some exceptions you should know about.
Before we get into a discussion about getting retirement funds early, and without penalty, we have to make a disclaimer. This article is NOT advocating that you dip into your tax-deferred retirement savings - unless it is the only thing standing between you and living on the streets. Aside from the fact that you will most likely owe income tax on the money withdrawn, funds in a retirement account get special consideration in bankruptcy proceedings. Specifically, all, or at least a majority, of your tax-qualified retirement assets are excludable from a bankruptcy estate. With individual retirement funds growing every year, this could mean a sizeable amount of money protected from creditors.
Now, let's talk about a few of the ways you can withdraw money from your individual retirement arrangement(s). Keep in mind that, for the purposes of this article, 'individual retirement accounts' include IRAs, SEP, and SIMPLE plans; the term 'qualified plans' includes 401(k), 403(b) and 457(b) types. Our discussion will assume that the terms of your employer's defined-contribution plan(s) allow early withdrawals.
The Simple Rules
Direct rollovers from one qualified plan trustee to another will completely avoid penalties and income taxes. If you receive a lump-sum distribution from a qualified plan and roll it into an IRA within 60 days, you also escape penalties and taxes. If all you are trying to do is move your money from one account to another, one of these methods will work for you, but there won't be any money to spend when the transaction is complete.
If you are permanently or totally disabled, the IRS allows you to withdraw money from your IRA or qualified plan without paying the early withdrawal penalty. Distributions to your beneficiaries upon your death also escape this penalty.
Unemployed individuals who use IRA money to pay health insurance premiums for themselves or their dependents also won't pay the additional 10%. This is one exception that is available to IRAs, but not on 401(k) or 403(b) plans. Other exceptions available only to the IRA owner are withdrawals of up to $10,000 for first-time home purchase and use of the funds to pay college expenses for you or a dependent.
If you withdraw money from an IRA or qualified plan to pay for medical expenses in excess of 7.5% of your adjusted gross income, you won't have to pay the penalty - and this exception applies whether or not you itemize deductions.
In an effort to be fair, the Internal Revenue Code also allows you to escape the 10% penalty on any money the IRS levies to pay a tax debt.
In addition to the exceptions related to both IRAs and qualified plans, there are some exceptions available only to participants in qualified plans. For example, if you are 55 or older and you retire or leave your job, you will not be penalized on a distribution from a qualified plan.
Any distributions that are required by a divorce decree or separation agreement (also known as a qualified domestic relations order) will also avoid a 10% penalty. If you are in the process of a divorce, and entitled to ½ of your spouse's account balance, make sure the divorce decree addresses your right to receive that money.
The Not-So-Simple Rules
Now that we have talked about the more understandable ways to avoid penalties on early withdrawals, there is one other exception of which you should be aware.
The rule is governed by Internal Revenue Code Section 72(t) and allows you to get to retirement funds if you receive the money under a series of "substantially equal periodic payments." This means that you have to commit to receive payouts (at least annually) from your retirement account based on your life expectancy. There are three methods of calculating the distributions that will qualify for this exception and you must receive the payments for at least 5 years to avoid penalties.
To say the least, this exception has great promise for those who need a little additional income or who wish to retire before age 59 ½. As with all potentially good things, there can be significant pitfalls and, if you wish to take advantage of this exception, it is best to seek professional advice.
At one time or another, you may be in need of funds that can only come from your retirement account. If you find yourself in this situation, talk to your CPA or financial planner before making any decisions on how you will handle the withdrawal. The potential savings can be significant. If you don't have a professional adviser, give us a call. We are here to help - it's what we do best.
Happy St. Patrick's Day.