Sometimes life doesn’t go according to plan, and sometimes what we’ve set aside for retirement must be used earlier than expected due to a job loss, disability, health crisis or other event. If this is the case, be warned that in addition to the distribution being taxable as income, there is a 10 percent penalty for withdrawing your retirement funds [from both a qualified retirement plan and an Individual Retirement Account (IRA)] before age 59 ½. But there are some exceptions to the penalty, depending on what type of retirement savings program you have and why your distribution is needed.
Both IRAs and qualified retirement plans [such as a 401(k) and 403(b)] allow distributions before age 59 ½ under the following circumstances:
- Death of the account owner/employee (this means that the beneficiary, regardless of age, isn’t penalized on the distribution).
- Disability of the account owner/employee (*be advised that the definition of disability in this case is very similar to that of Social Security disability).
- If distributions are made as a “Schedule of Substantially Equal Periodic Payments” for the account owner’s lifetime (or at least for the later of five years or until they are 59 ½).
- For medical expenses that exceed 7.5 percent of the taxpayer’s Adjusted Gross Income or AGI (*note that this is also the threshold for deducting medical expenses on your income taxes).
- To pay the Internal Revenue Service (IRS) if a levy is assessed against the IRA or qualified plan.
- There is also an exception to the 10 percent for a distribution taken by a reservist who takes a distribution while on active duty and is called to active duty for more than 179 days.
The rules vary from here. IRA owners are allowed to take early withdrawals without the penalty if the distribution is needed to pay for:
- Health insurance premiums for the self employed
- Higher education expenses for the taxpayer, his/her spouse, child or grandchild
- A first time home purchase ($10,000 lifetime maximum)
Qualified plans, on the other hand, permit penalty free early withdrawals if:
- The account owner/employee is at least age 55 and separated from service.
- The distribution is made to an alternate payee pursuant to a Qualified Domestic Relations Order (QDRO) — in other words, the distribution is made to a former spouse as part of the divorce decree.
While distributions may be exempted from the penalty, not all qualified plans permit in service withdrawals; you would need to check with your plan administrator. In addition, accessing retirement funds may not be the best option for a temporary cash flow issue. A meeting with a financial planner will help you determine what options may be most beneficial for you.
FPA member Amy Jo Lauber, CFP®, is President of Lauber Financial Planning in Buffalo, N.Y.