7 ways to avoid the IRA early withdrawal penalty

7 ways to avoid the IRA early withdrawal penalty

Follow this easy, actionable advice to protect yourself and your retirement savings.

Gail Kellner

Published December 2nd, 2020

Table of Contents

Key Takeaways

  • Taking money out of your IRA before retirement should be a last resort.
  • The IRS will take a 10% early distribution fee if you take money out early.
  • There are a few ways to avoid this 10% fee if you absolutely need to.

If you’re years away from retirement but in need of quick cash, you may be tempted to take it from your IRA. But the IRS will take a 10% early distribution tax if you try to tap into your IRA before the age of 59 and 1/2. They’ll also tax it as income, so it’s a significant penalty. They do that to encourage you to leave your retirement savings for retirement. There are some circumstances, however, where you may be able to borrow from your IRA without penalties. Let’s go over eight ways you can avoid the penalties for early withdrawal.

Delay IRA Withdrawals until 59 and ½

The easiest way to avoid any penalties on withdrawing money from your traditional IRA is to wait until you’re 59 and ½. The money will still be taxed as income, but you won’t pay any additional penalties. Remember when you contributed to your IRA in the first place and it was tax deductible? Now the IRS wants their share.

Use an IRA Withdrawal for Hardship Expenses

It depends on why you need to withdraw the money, but the IRS does have some expenses they consider a hardship and will not apply the 10% penalty. Here are the most common:

  • Higher education
  • Unreimbursed medical expenses
  • First-time home buyers
  • Medical insurance if you’re unemployed

These are the only expenses the IRS doesn’t apply the penalty for, and even with these, there are exceptions.

While the IRS won’t apply a penalty on these withdrawals, you should only consider drawing from your retirement funds as a last resort. By withdrawing investment funds early, you could be denying your future self the potential returns on your investments, which will compound over time. Plus, if you’re working when you take these hardship withdrawals, you’ll increase your total income for the year and possibly put yourself in a higher income tax bracket.

Higher Education: You can use the money to pay the tuition for yourself, your spouse, you or your spouse’s child, adopted child, foster child or grandchild. They must be at least a half-time student at an accredited college or university. Keep in mind that any withdrawals you make from a traditional IRA will be taxed as income and could possibly affect your student’s financial aid package.

Unreimbursed medical expenses: If you have medical expenses that were not covered by insurance, you might be able to take a penalty-free withdrawal from your IRA. The medical expenses must exceed 10% of your adjusted gross income, and you must pay the expenses in the same calendar year you took the withdrawal.

First-time homebuyers: The IRS considers you a “first-time” homebuyer if you haven’t owned a home in the previous two years. You can withdraw up to $10,000 to buy, build, or rebuild a first home. If your spouse also has an IRA, he/she can withdraw $10,000 for the same home purchase. You can use this money to help a child or grandchild purchase a home as well. However, the $10,000 is a lifetime limit.

Medical insurance if you’re unemployed: If you lose your job, you can tap into your IRA to pay for health insurance. You must receive unemployment for at least 12 consecutive weeks and receive the money either in the year you received unemployment or the next year. You also have to receive the money no later than 60 days after you find a new job.

IRA Withdrawal for Disabilities

If you or your spouse become disabled and can no longer work, you can take a disbursement from your IRA without a 10% penalty. The IRS will want to see proof from a doctor that you are permanently and totally disabled, which they define as:

  1. Someone who can’t engage in any substantial gainful activity because of a physical or mental condition AND:

  2. A qualified doctor determines that this condition can be expected to last for at least a year or can be expected to result in death.

If you can work in any way (minimum wage or higher), even if it’s not what you spent your career doing, you probably can’t take the disbursement.

One example: Mary used to be a salesperson in a retail store. She retired on disability because she can’t stand for eight hours straight anymore. However, she now works as a full-time babysitter for a neighbor. She is not eligible to utilize her IRA money penalty-free because she is engaged in a gainful activity.

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IRA Withdrawal during active-duty military service

If you are a qualified reservist, you are not subject to the 10% penalty on early IRA distributions. To meet the IRS’s definition of a qualified reservist, you must meet the following criteria:

  • You were ordered or called to active duty after September 11, 2001.
  • You were ordered or called to active duty for a period of more than 179 days or for an indefinite period because you are a member of a reserve component.
  • The distribution is from an IRA or from amounts attributable to elective deferrals under a section 401(k) or 403(b) or similar arrangement.
  • The distribution was made no earlier than the date of the order to active duty and no later than the close of the active duty period.

Set up an annuity

You can arrange to take out “substantially equal periodic payments” (SEPP’s) based on your life expectancy. These are also called 72(t) payments because that’s the section of the tax code you can find it under.

You have to take the same amount of money for five years or until you turn 59 ½, whichever comes later. You can’t stop in the middle, or the IRS will collect the penalty on all of the money, plus interest.

It may seem like a good idea if you need extra cash, but keep in mind that money will no longer be waiting for you when you retire.

Withdraw contributions from a Roth IRA

You can make withdrawals on contributions you make to a Roth IRA even if you’re younger than 59 and ½. However, you can’t tap into the investment earnings before you’re 59 and ½ without incurring the 10% IRA penalty unless you meet the exceptions. Most of the Roth IRA withdrawal rules are the same as for accessing a traditional IRA. The one addition is that you can withdraw up to $5,000 after the birth or adoption of your own child without paying a penalty.

Withdraw from an inherited IRA

If your spouse dies and leaves you their IRA, you can either add the money to your own IRA or you can leave it where it is. If you’re younger than 59 and ½ you’ll be subject to all of the same rules about withdrawing the money: first-time home buyer, medical expenses, etc.

If you inherit an IRA from someone who is not your spouse, you can’t transfer the money into your own retirement account. You have to open a new IRA in your own name and transfer the money to this new account. You can’t make contributions to this account and you must start taking distributions the year after the owner dies.

You have three choices as to how to take the distributions.

  • Lump sum payment
  • Following the passage of the SECURE Act in 2019, non-spousal inherited IRAs must be fully distributed within ten years of the account owner's death

You need to make sure you take the required minimum distribution, because otherwise the IRS will incur a 50% penalty on the money that wasn’t withdrawn on time.

Bottom Line

All of the laws regarding retirement accounts and what you can and can’t do with the money can be very complex. If you guess wrong, you’ll be subject to hefty penalties and taxes. Before you consider withdrawing money from an IRA, talk to a Certified Financial Planner® from Retirable. They can help you wade through the ever-changing rules and exceptions on IRAs and make the best financial choice for you.

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Gail Kellner

Gail Kellner lives with her husband, two sons, and various fur-children. She writes about personal finance and insurance mostly, with a little bit of parenting thrown in. She also writes YA Fantasy fiction in her spare time, and her first YA novel will be published later this year.

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