Yahoo Finance How to Avoid Penalties on Early Retirement Distributions
Pulling from your retirement fund before retirement is certainly less than ideal. Approaching retirement without the resources to replace your income or cover your expenses is a frightening scenario. In addition to pulling from assets that you will need in the future, there are severe taxes and penalties you will have to pay if you don't execute the move property. Assuming you are in the 25 percent federal tax bracket and subject to the 10 percent early withdrawal penalty, you would need to withdraw $15,385 to receive $10,000 in total. That $5,385 haircut consists of $1,539 of penalties and $3,846 of federal taxes.
[Read: The 7 Best Tax-Advantaged Accounts for Retirement Savings.]
However, sometimes life happens, and there maybe a good reason you need to tap into those assets prior to age 59 1/2. Below is a detail of exceptions and ways to access your IRA assets, but please read with an eye toward understanding that this could be a costly maneuver. It is also paramount to understand that none of these exceptions exempt you from paying income taxes on your early withdrawals. This list provides an opportunity to avoid early penalties, but ordinary income taxes would still be due.
Medical expenses. Medical costs are often an unknown and unplanned-for expense. If you need to utilize your IRA assets to cover these, the medical expenses that will be penalty-free are the costs that exceed 10 percent of your adjusted gross income. This really impacts the viability of this distribution unless it is a very large expense, and a portion of the distribution would still be penalized. For example, if your income is $100,000 per year and you are 55 and pulled $15,000 from your IRA or 401(k) to cover $15,000 of medical expenses, you would still pay $1,000 in penalties on the first $10,000 of the distribution. It is also important to remember that the distribution needs to occur in the same tax year as the medical expense.
Health insurance premiums while you are out of work can also be a permissible distribution from your IRA. If you have been collecting unemployment for at least 12 consecutive weeks, you can pay your health insurance premiums penalty-free.
Two other medical-related exceptions that allow you to avoid penalties are death or permanent disability of the participant or IRA owner.
Early retirement. Early retirement is exciting, but it needs to be well planned for. IRA holders who retire early can implement a series of equal payments to fund retirement penalty-free (known as substantially equal periodic payments). The IRS provides three methods to calculate your SEPP amount, and you can choose the method that best fits your cash-flow needs. The methods of calculation are amortization method, annuitization method or required minimum distribution method. This option can be tremendously effective for individuals who want to retire much earlier than normal. The only catch is that you will be stuck with your decision for either five years or until you reach 59 1/2, whichever comes last.
[Read: 5 Challenges of Early Retirement.]
Education. Within IRAs, you can fund education goals penalty-free for you, your spouse, your child or your grandchild if the student is enrolled more than half-time at an eligible institution. Qualified expenses include tuition, fees, books, supplies and room and board. Be careful with this option if you are reliant upon financial aid. IRA account distributions will count as income on the following year's Free Application for Federal Student Aid. It is also important to remember that there are not scholarships, grants or loans for retirement. Using retirement assets for education is less than ideal.
Home purchase. Buying a home is another exception that only applies to IRA accounts, and the IRS language specifically mentions first-time home buyers. Who does the IRS consider a first-time home buyer? Anyone who has not owned a principal residence at any time during the past two years. The maximum distribution that will be penalty-free is $10,000 per individual. Your spouse may also qualify individually for this distribution, resulting in $20,000 that will avoid the 10 percent penalty.
Miscellaneous exceptions. Reservists called to active duty can also receive payments from IRAs, 401( k)s and 403( b)s without having to pay the early-distribution tax.
This is a bit of a funny one, but the IRS will allow you to pay a tax levy penalty-free from your IRA. There is a reason there are jokes about "death and taxes."
Other ways to access retirement assets penalty-free. On a few of the items listed above, IRAs provided more opportunities to avoid penalties than your employer-provided 401(k) or403(b). However, your employer plan has a few tricks up its sleeve, too.
Your employer may allow you to pay for hardships with a loan from your retirement plan. What is unique about a loan from your retirement plan is that you are loaning yourself the money and then paying yourself back. A big caution: If you leave employment with an outstanding loan, the balance will be deemed an early withdrawal and subject to penalties and taxes.
If you leave your employer during or after the year you reach age 55 (age 50 for public safety employees), you can access the plan assets penalty-free.
[Read: What's Your Retirement Personality Type?]
Another interesting thing to note is that governmental 457(b) distributions are not subject to the 10 percent additional tax.
Financial Independence is a marathon that requires long-term planning, forced scarcity of lifestyle and the vision to remain disciplined no matter what life throws your way. There are opportunities to access the assets that you are counting on to replace the power of your brain, back and hands early. However, it is important to prioritize what events constitute true emergencies versus temporary hardships. There is nothing wrong with measuring twice and cutting once to ensure you are not handicapping your future. As we mentioned earlier, employing any of these exceptions should be implemented with an eye toward caution. Fear is appropriate when handling such a dangerous tool of early retirement distributions.
Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show."
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