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How to Make Penalty-Free IRA Withdrawals

Knowing the exceptions to the 10 percent tax rule could save you serious money

By Bill Bischoff | MarketWatch | November 18, 2013

In this still-struggling economy, you may need to take an early IRA withdrawal to gain some needed cash. By early withdrawal, I mean one that occurs before you’ve reached age 59 1/2. Needless to say, there are tax implications, including the possibility of getting socked with the 10 percent premature withdrawal penalty tax. But you may be able to avoid that tax, if you qualify for one of the exceptions.
 
The Penalty Can Often Be Avoided
 
In most cases, all or part of any withdrawal from a traditional IRA will count as taxable income. The taxable percentage depends on whether you’ve made any nondeductible traditional IRA contributions over the years. If you have, each withdrawal consists of a proportionate amount of your total nondeductible contributions (to however many IRAs you own), and that part is tax-free.

(MORE: To Tap Your Ira or Not)

The proportionate part of each withdrawal that consists of deductible contributions and accumulated earnings (from all your traditional IRAs) is taxable. If you’ve never made any nondeductible contributions, 100 percent of any traditional IRA withdrawal will be taxable.
 
While it may be impossible to avoid triggering some taxable income by taking an early withdrawal, you might be able to avoid the 10 percent penalty tax by taking advantage of several exceptions. Here’s a list of them, along with brief explanations:
 
Substantially Equal Periodic Payments (SEPPs)
 
SEPPs are annuity-like IRA withdrawals that you must take at least annually. There are three methods for calculating them. One is relatively simple; the other two are complicated. The amount of the penalty-free SEPP that you can take each year can vary by thousands, depending on which method you choose.
 
You must continue taking SEPPs from the annuitized account for at least five years or until age 59 1/2, whichever comes later. If you don’t stick with the program, the taxable portion of all pre-age-59 1/2 withdrawals from the annuitized account can be hit with the 10 percent penalty tax. Ditto if you take more or less than the annual SEPP amount from the annuitized account. That’s why I recommend seeking advice from a tax pro before embarking on a SEPP program that would involve substantial dollars.

(MORE: 6 Investment Mistakes That Can Ruin Retirement)
 
Withdrawals to Cover Medical Expenses
 
If you pay medical expenses that exceed 10 percent of your adjusted gross income (AGI) for the year, you can take penalty-free early IRA withdrawals up to the excess amount. (AGI is the number at the bottom of page 1 of your Form 1040; it includes all your taxable income items and is reduced by certain deductions such as alimony paid to an ex-spouse and moving expenses.)
 
Withdrawals for Education Expenses
 
Early IRA withdrawals are penalty-free to the extent you pay qualified higher education expenses during the year. The expenses must be for the education of you, your spouse, or a child, stepchild, or adopted child of you or your spouse.

(MORE: Gain Access to Retirement Savings)
 
Withdrawals to Pay Health Premiums While Unemployed
 
This exception is limited to those who receive unemployment compensation for 12 consecutive weeks under any federal or state unemployment compensation law during the current year or the preceding year. Early IRA withdrawals taken during the current year are penalty-free up to the amount paid during the year for health insurance premiums to cover you, your spouse, or your dependents. However, early withdrawals taken after regaining employment for at least 60 days won’t qualify for penalty-free treatment.

Withdrawals After a Disability
 
Early IRA withdrawals taken by an account owner who is physically or mentally disabled to the extent that he or she cannot work in his or her usual job or business activity or a similar job or business activity are exempt from the 10 percent penalty tax. The disability must be expected to be of long or indefinite duration (although it need not be permanent) or lead to death.
 
Withdrawals for a First-Time Home Purchase
 
Subject to a $10,000 lifetime limit, you can take penalty-free early IRA withdrawals to cover amounts spent within 120 days on qualified home acquisition costs. The home must be a principal residence acquired by you, your spouse, your child, grandchild, or grandparent — or your spouse’s child, grandchild, or grandparent. The buyer (and spouse if applicable) must not have owned a principal residence within the two-year period ending on the home acquisition date.
 
Withdrawals to Satisfy IRS Levies
 
Early IRA withdrawals taken by the IRS to pay federal tax levies against the IRA itself (as opposed to levies against the account owner) are exempt from the 10 percent penalty tax.
 
Withdrawals by Military Reservists
 
Qualified early withdrawals taken by military reserve members called to active duty for at least 180 days or for an indefinite period are exempt from the 10 percent penalty tax.
 
Withdrawals after Death
 
Amounts paid to a deceased IRA owner’s estate or account beneficiary after the account owner’s death are exempt from the 10 percent penalty tax.
 
The Bottom Line
 
If you must take IRA withdrawals before age 59 1/2, the tax planning goal is to avoid the 10 percent penalty. As you can see, various exceptions are there for the taking, and they can save your bacon. For more details, go to www.irs.gov and check out Publication 590 (Individual Retirement Arrangements).
 
Oddly enough, some of the penalty tax exceptions for IRAs are not available for early withdrawals from qualified retirement plan accounts, such as 401(k) accounts.

Bill Bischoff covers tax and retirement issues for MarketWatch.com.