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Exceptions to the 10% Early Withdrawal Penalty from IRAs and 401(k)s

English: A clock made in Revolutionary France,...

English: A clock made in Revolutionary France, showing the 10-hour metric clock. (Photo credit: Wikipedia)

When you take money out of your IRA or 401(k) plan (or other qualified retirement plan, such as a 403(b) plan), if you’re under age 59½ in most cases your withdrawal will be subject to a penalty of 10%, in addition to any taxes owed on the distribution.  There are many exceptions to this rule though, and the exceptions are not the same for all types of plans.  IRAs have one set of rules, and 401(k)s have another set of rules.

The exceptions are always related to the purpose for which the money was withdrawn.  The exact same dollars withdrawn do not have to be used for the excepted purpose, just that the excepted expense was incurred.

IRA Exceptions

It is important to know that all distributions from your traditional IRA are subject to ordinary income tax, but some distributions are not subject to the early withdrawal penalty.  The list of exceptions for early withdrawals from IRAs is as follows:

Death of the owner of the IRA – if the owner of the IRA dies, the beneficiaries of the IRA can (in fact, must) take withdrawals from the plan without paying the 10% penalty.

Total and permanent disability of the owner of the IRA – if the owner of the IRA is deemed to be totally and permanently disabled.   You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

SOSEPP – With a Series of Substantially Equal Periodic Payments, lasting at least five years or until age 59½ (whichever is longer), there is no 10% penalty applied.

Medical Expenses – if you have medical expenses greater than 7.5% of your Adjusted Gross Income, a distribution from your IRA to cover these expenses (the excess above 7.5% of AGI) will not be subject to the penalty.  Any amounts paid by insurance toward the medical expenses reduces the overall expense counted toward the excepted expenses.

Health Insurance Premiums – if you’re unemployed, you can take a distribution from your IRA to cover your health insurance premiums without paying the penalty.

Qualified higher education expenses – amounts withdrawn from your IRA to pay for tuition, fees, books, supplies, and equipment needed for enrollment or attendance of a student at an eligible higher education institution are not subjected to the penalty.  In addition, if the student is at least a half-time student, room and board expenses paid for with an IRA distribution would not be subject to the penalty.  The amount of education expenses is reduced by any scholarships, grants, and qualified 529 plan distributions; any amount applied to an IRA penalty exception is also not eligible to be used toward education credits, such as the American Opportunity Credit or the Lifetime Learning Credit.

First-time home purchase – amounts withdrawn from your IRA up to $10,000 that are used toward a qualified first-time home purchase are an exception to the penalty.

Qualified reservist distributions – if a reservist who is called to active duty after September 11, 2001 for a period of 179 days or more takes a distribution from an IRA (after the start of active duty and before the end of active duty) the distribution will not be subject to the 10% penalty.

Rollovers – both direct, trustee-to-trustee transfers and 60-day indirect transfers are exempted from the penalty.

Excess contributions – if you have contributed too much to your IRA, you can take out the excess contribution without penalty.  However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

401(k) Exceptions

As with the IRA, most withdrawals from a 401(k) or other qualified retirement plan are subject to taxation.  Early withdrawals before age 59½ are also subject to a 10% penalty, with some exceptions.  The exceptions are as follows:

Death of the participant – this is the same as the exception for an IRA above.

Total and permanent disability of the participant – same as with an IRA.

SOSEPP – same as with an IRA.

Medical Expenses – same as with an IRA.

Qualified reservist distributions – same as with an IRA.

Rollovers – same as with an IRA.  However, an indirect 60-day rollover (not a trustee-to-trustee transfer) is subject to mandatory 20% withholding.  If the withheld 20% is not transferred within 60 days, this amount may be subject to both taxation and the 20% early withdrawal penalty.

Corrective distributions – just like with an IRA, if you have contributed too much to your 401(k), you can take out the excess contribution without penalty. However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

Separation from service after age 55 – if you leave employment after the age of 55, you are eligible to take distributions from your 401(k) or other QRP without penalty.  This is only valid while the funds are still in the 401(k) – if you rollover the funds to an IRA, this option is no longer available.  If the participant is a public safety employee (police, fire, or emergency medical technicians), the age is 50 or older.

Qualified Domestic Relations Order (QDRO) – in the event of a divorce, if the 401(k) is to be divided or distributed to the ex-spouse of the participant, withdrawals from the plan by the ex-spouse are not subject to the 10% penalty.

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6 Comments

  1. BarryNo Gravatar says:

    On the 401(k) exceptions, I believe your eligible if you leave your job at anytime during the calendar year in which you turn 55 according to Pub 575, but you can’t actually take the distribution until after turning 55?

    1. jblankenshipNo Gravatar says:

      That is right, Barry – the separation from service can occur at any time during the calendar year when you’ll reach age 55 (50 for public safety employees), and as long as the distributions occur after you’ve actually reached age 55 there will be no penalty. This is only from QRPs, not from IRAs.

      jb

  2. clydewolfNo Gravatar says:

    Good information all in one place! Thank you.

    A question about the medical expenses exceeding 7 1/2 % of a taxpayer’s AGI,
    Will the PPACA (obamacare) increase of the medical deduction increase the threshold for the exemption to 10% which is now in place for those under age 65?

    Comment on the “first time home buyer” exemption of the 10% penalty, this is a once a lifetime opportunity. Under the rules, it is possible to be a “first time home buyer” more than once.

    As for distributions from the 401k, typically the taxpayer must separate from the employer that sponsors the 401k before distributions can be made from the 401k.

    1. jblankenshipNo Gravatar says:

      Good points, Clydewolf.

      I had wondered about the 10% of medical expenses question myself but couldn’t find any definitive information about it. I’ll keep looking and post something when I find out.

      Re: first-time homebuyers, you can be a first-time homebuyer many times in your life, it’s not a one-time deal. If you haven’t had a present interest in a main home for 2 years or more, when you purchase a main home you’re considered to be a first-time homebuyer. Incidentally, that’s different from being a first-time homeboy. Totally different thing! :)

      jb

      1. DanNo Gravatar says:

        Question: While you can use the first time home buyers exemption more than once, is it capped at a 10k limit for life? That was my understanding of the exception.

        1. jblankenshipNo Gravatar says:

          Dan, that’s absolutely correct. Under current law, it is a lifetime cap of $10,000 per individual excepted from penalty for the first-time homebuyer purpose.

          jb

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