Withdrawing money out of a retirement account is never ideal, but if you meet specific criteria, you may be exempt from paying the 10% tax.
In extreme cases, you should consider withdrawing cash from your pre-tax retirement savings before age 5912. Doing so will result in a 10% penalty in addition to the regular income tax.
Rather than withdrawing from a retirement account, it’s preferable to use funds from a joint, single, or most trust account, from which there is no penalty for withdrawing funds early, and you would pay much less tax.
The truth, however, is that occasionally people have no choice but to tap into their pre-tax retirement savings plan for emergency funding. Although income tax is unavoidable, the early withdrawal penalty of 10% is occasionally negotiable in this scenario.
The best way to avoid a penalty that isn’t necessary is to learn which retirement plans fall under the umbrella of the exception.
Many people who withdraw from their retirement accounts have to pay the penalty because the exception they relied on did not cover their specific situation. Most of the 10% penalty exclusions apply to both workplace plans and IRAs, but as we’ll see, several beneficial exceptions apply solely to one or the other.
There are generally three types of early-withdrawal exceptions that can help you keep track of which one applies to your retirement plan:
The 10% Penalty Exemption Includes “Both” Employer-Sponsored and Individual Retirement Accounts.
Distributions to beneficiaries upon death, incapacity, unreimbursed medical expenses above 7.5% of adjusted gross income (you do not need to itemize to use this exception), conversions to a Roth IRA, and gifts of up to $5,000 for the birth or a child’s adoption are not subject to tax.
The SECURE Act 2.0 of 2022 also added some new exemptions to existing law. The new law allows people to access their retirement funds in the event of domestic violence, natural disaster, or terminal illness. In addition, a new exception for unexpected personal expenses of up to $1,000 will be implemented in 2024.
Finally, you must withdraw funds from your retirement account before age 59 1/2. In that case, you can avoid paying a 10% penalty by agreeing to take distributions in the form of Substantially Equivalent Periodic Payments for the very least five years or until age 59 1/2, whichever comes first.
Specifically IRA-Related Exceptions.
You can use this money for a variety of things in the event you lose your job, such as paying for healthcare, further education for yourself or your family, or putting down a down payment of up to $10,000 on a property.
Limited to “Just” Employer-Sponsored Retirement Programs.
There are two major ones here.
One such circumstance is reaching age 55. If you quit your job on or after December 31 of the calendar year in which you turn 55 (or 50 if you are a qualified public safety employee), you won’t have to pay the 10% early distribution penalty on any distributions you receive. The other is the QDRO, which allows a spouse to take funds from a retirement account without being subject to the 10% penalty that would otherwise apply in the event of a divorce.
Remember the adage, “what you don’t know can damage you,” if you find yourself in the unenviable position of tapping into your pre-tax retirement plan to cover an unexpected expense. In addition to learning the exceptions, you should study which ones apply to which retirement programs. The money you avoid paying in fines might be in the thousands.