- Withdrawals from your retirement accounts prior to age 59 1/2 are subject to a 10% penalty by the IRS.
- If you can, make a withdrawal only when it’s one of the approved exceptions that avoids the 10% penalty.
- Required minimum distributions begin at age 70 1/2, so invest a much as you can before then.
It’s a given that retirement savings are important. Without them, your financial security when you decide you can’t or don’t want to work anymore could be jeopardized. Despite this, 21% of Americans have no retirement savings at all. So, if you worked hard to build up an individual retirement account (IRA), why would you want to take money out?
It’s possible you lost your job and need money to tide you over. Or, maybe your family was hit with an unexpected tragedy, like the loss of a family member or even a natural disaster that wrecked your home.
Before we get any further, let’s first look at the primary types of IRA accounts to understand how each one works, then we’ll discuss the rules for withdrawing funds.
Note: If you need a refresher on the differences between an IRA and a 401k, read our IRA vs. 401k guide here.
A traditional IRA allows you to deposit money that reduces your taxable income for the year (subject to earnings limits). Furthermore, the earnings on the account are tax-deferred until you actually retire. This means you won’t be taxed for the money until you actually retire and tap into your retirement account.
The big perk with the deferment is that the earnings on your contributions are compounding, meaning the earnings are being reinvested and themselves also gaining returns, without any reduction for taxes. When you retire and lose the income from your salary, you might also be in a lower tax bracket, versus during your peak earning years. This can result in thousands saved by not having to pay a higher tax rate on that money.
The simplicity of the traditional IRA makes it an essential part of many workers’ retirement planning.
A Roth IRA is similar in function to the previous models, but can only be contributed to after regular income tax is taken out. With this tax-free money deposited, the money can then be withdrawn at retirement totally tax free. It also grows tax free, which can result in substantial growth during the life of the account. Of the options listed, this one is the most advantageous to reduce taxable income at retirement, but again, it requires after-tax money in the first place.
In 2019, both the traditional and Roth IRAs have a yearly income contribution cap of $6,000 ($7,000 if you’re 50 and over).
IRA Withdrawal Rules: Avoiding the 10% Penalty
The age to remember for IRAs is 59 1/2 years old, when any withdrawal taken at that point or after isn’t penalized. You’ve put in your time and as the account holder, and you’ve earned your retirement pay that’s free of any tax penalty. But for withdrawals prior to reaching 59 1/2, the IRS imposes a penalty to dissuade people from tapping into their retirement savings prematurely.
As is the case with all rules, there are IRS exceptions to the 10% penalty. Unlike 401k plans, there are actually more exceptions with IRAs.
It’s advisable you speak to a tax advisor or financial advisor before making a withdrawal, but here are some of the common IRA distributions that avoid the early withdrawal penalty of 10%.
You’re Buying a Home
If you’re about to purchase your first home you can use up to $10,000 from your IRA to cover the cost. This also applies to your spouse if you’re both purchasing, meaning you can get a combined $20,000. When the IRS says “first home,” they really mean you or your spouse haven’t owned a primary residence in two or more years. Once you’re approved, you have 120 days to use your money towards the home.
You’re Covering Health Insurance Premiums or Medical Expenses
If you have medical expenses that haven’t been reimbursed, and these expenses exceed 10% of your adjusted gross income, you can use money from your IRA to cover the expenses. This money can also be used to cover you and/or your family’s health insurance during your time of unemployment.
You’ve Become Permanently Disabled (or Worse)
If you’re put on permanent disability and can no longer work, the IRS will allow you to take out your IRA funds penalty-free. If you pass away, your beneficiaries or estate will receive your IRA money penalty-free as well.
You Have Qualified Higher Education Expenses
IRA withdrawals can be used for qualified education expenses. If you or your spouse, children, or grandchildren seek higher education, your IRA money can be taken out penalty-free. This money can be used to cover tuition, room and board, books, supplies, and other fees. To pay for room and board you do need to attend school more than part-time.
You’re Now Active Duty and Have Left Reservist Status
If you were reserve status in the military and have now been called to active duty for 179 days or more, you can withdraw your IRA money sans penalty. This money can be used for any number of things, including caring for your family or dependents in your absence.
Substantially Equal Periodic Payments
A Substantially Equal Periodic Payment (SEPP) is a periodic payment plan that allows individuals to withdraw funds from your retirement accounts prior to the age of 59 1/2 while avoiding the 10% penalty.
However, there are several stipulations in order to qualify and important and somewhat complex steps to follow. If this method of withdrawals is your only option to withdraw from your IRA, be sure to consult a tax adviser to structure your SEPP properly.
Tax and Penalty-Free Roth IRA Withdrawals
With all the above applying to penalty-free withdrawals from both Traditional and Roth IRAs, Roth IRA withdrawals on your contributions and earnings are treated differently. First off, contributions (money you deposited into your Roth) can be withdrawn without any penalty at any point in time, even if you’re under 59 1/2. Although a separate emergency account is always advisable, your Roth IRA contributions could be the next asset you tap in case of an emergency.
Earnings on the Roth IRA, however, can be taxed and penalized if you make non-qualified withdrawals.
If you’re over 59 1/2 and make any kind of withdrawal (contributions first, followed by earnings), it’s considered qualified and will be exempt from the taxes and 10% penalty.
Non-qualified distributions of earnings on the Roth, which are subject to taxes, occur when withdrawals are made under age 59 1/2 and/or the contributions were in the account for less than five years (even if you’re over 59 1/2). If the earnings withdrawal meets one of the hardship conditions described above, you are saved from the penalty but not the income taxes.
Here’s a simple example: Meet Justin. Justin contributed $5,000 to his Roth IRA three years ago after a big bonus; he had already contributed enough into his 401k to take advantage of the employer match.
His Roth IRA grew with an aggressive portfolio and a rising stock market, and it is now almost $6,000 — showing earnings of almost $1,000. Justin can withdraw up to the $5,000 he contributed without paying income taxes or penalties — even though he’s under 59 1/2 and hasn’t owned the account for five years.
If he decides to withdraw the entire $6,000, then the earnings of $1,000 will be subject to both income tax and the 10% penalty because he hasn’t met the age and holding period requirements. He can avoid the penalty, but not the tax, if his withdrawal meets one of the hardship distributions such as using the earnings to purchase his first house.
Does a 401k Account Get Penalized the Same?
If you have a 401k, which is likely if you have a full-time job, you might be wondering if those face the same penalties as the above IRA types. While a 401k account is penalized for early withdrawals, things are handled a little differently and you have some options:
- If you’re taking money out of a 401k account before the retirement age of 59 1/2 you will incur a 10% penalty unless you qualify for one of the many distribution exceptions. One exception to this is if you separate from service (quit your employer who sponsors your 401k) at age 55, then you can withdraw funds from your 401k without penalty.
- Unlike IRA withdrawals which are exempt, 401k withdrawals for first-time home purchase and higher education expenses are not exempt from the penalty.
- If you’re leaving an employer or an employer 401k account is being shut down, you can roll it over into a new 401k account or an IRA to avoid the 10% penalty.
For more information on how 401k accounts are handled, read our full guide on 401k withdrawals that details the penalties, how to avoid them, and best practices.
Will You Ever Be Required to Withdraw Money?
Once you hit 70 1/2 years old, the IRS requires you to start taking required minimum distributions (RMD). These distributions have to happen at least annually, and for Traditional IRAs they are considered taxable ordinary income. The IRS likes their tax money and won’t let you sit on that nest egg forever.
The only exception to this rule is a Roth IRA which not only offers tax-free withdrawals, it also doesn’t require an RMD as long as the owner of the account is alive.
The silver lining here is that from the ages of 59 1/2 to 70 1/2 you have flexibility to leave your money alone, up your contributions, or withdraw your funds without any 10% penalty. If you’re in the sweet spot of not having to make withdrawals even after age 59 1/2, speak to a financial advisor about how you can maximize your earnings and growth until your RMDs start. (You could even start these conversations now, regardless of how many years away that is.)
401k vs. IRA: Summary of Most Common Withdrawals
|Will the withdrawal be exempt from the 10% additional early distribution tax (penalty)?||401k|
(also known as “Defined Contribution Plans” or “Qualified Retirement Plans”)
|Individual Retirement Account|
|Age 59 1/2 or older||Yes: Exempt, not subject to penalty|
Age 55 if separate from service (age 50 if in a government employee plan)
|Yes: Exempt, not subject to penalty|
No need to separate from service, but must be 59 ½ or older
|First time home purchase||No: Not exempt, subject to penalty||Yes, up to $10,000|
|Higher education expenses||No||Yes|
|Unreimbursed medical expenses (>7.5% AGI; 10% if under age 65)||Yes||Yes|
|Health insurance premiums paid while unemployed||No||Yes|
|Series of substantially equal payments (SEPP)||Yes||Yes|
|Death or disability of account owner||Yes||Yes|
Retirement: Your Way
Financial experts will tell you to avoid withdrawing money from your IRA if you don’t have to. But life can be unexpected, and there may come a time when you simply need to take money out. The important thing is that you’re knowledgeable on the repercussions and prepared to take the next steps.
Contribute as much as you can to savings like your IRA to plan for a more secure retirement. With more exemptions to withdrawal penalties, consolidating your 401k from previous employers into an IRA might make sense for you. Before you make any kinds of withdrawals, be mindful of the rules and consult with a tax or financial advisor.
Hopefully you won’t have to worry about taking any money out of your IRA for many years to come, as you only get one retirement. Contribute to your accounts now and consistently to grow your retirement savings, and make your retirement the best possible.