How to Make Penalty-Free IRA Withdrawals
Knowing the exceptions to the 10 percent tax rule could save you serious money
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.
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
Withdrawals to Pay Health Premiums While Unemployed