Taking money out of a traditional IRA before age 59 ½ usually means a tax and an early withdrawal penalty. However, there are exceptions to those taxes.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) introduced a penalty-free withdrawal option for those impacted by the coronavirus. Affected individuals can withdraw up to $100,000 without an early withdrawal penalty until December 20, 2020. Know that there are no exceptions to paying ordinary income tax on the amount withdrawn.
CARES Act Withdrawals
There’s no IRA early withdrawal penalty for hardship in the CARES Act. You must meet one of the following qualifications to make a withdrawal:
- You, your spouse, or a dependent is diagnosed with COVID-19.
- You’re experiencing financial consequences from COVID-19, including not working due to being quarantined, furloughed, or laid off, or you have a reduction in hours.
- You’re experiencing financial consequences because you don’t have adequate child care due to COVID-19.
- You own a business and you had to close or reduce hours due to COVID-19.
While you won’t have to pay an early withdrawal penalty, you will owe income taxes, like other withdrawals. Unlike other withdrawals, you have three years to pay those taxes and three years to repay the money to your IRA if you choose.
Here are some of the exceptions. Before making any withdrawals, we recommend you contact a tax professional before making any decisions.
Medical Expenses
You might qualify for an exemption from the IRA penalty tax if you used your IRA early withdrawal to pay medical expenses that are more than 7.5% of your adjusted gross income.
Health Insurance
If you are unemployed, used the IRA early withdrawal to pay for your medical insurance, and you meet the additional requirements below, you may be exempt from an early withdrawal penalty:
- You received unemployment compensation paid under federal or state law for 12 consecutive weeks because you lost your job.
- You receive the IRA withdrawal during either the year you received the unemployment compensation or the following year.
- If you have since been re-employed, you cannot have received your IRA withdrawal more than 60 days after your new employment started.3
Disability
If you’re disabled, plan on a doctor’s verification to qualify for an exception to the penalty tax. According to the IRS, “You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or be of long, continued, and indefinite duration.”
Inherited IRA
You Inherit an IRA in the following ways:
- If you inherit an IRA from a non-spouse, even if the IRA owner was under age 59 1/2, you will not have to pay the penalty tax on amounts withdrawn. You will still have to include any IRA withdrawal in your adjusted gross income (AGI).
- If you inherit an IRA from a spouse, and you choose to treat it as your own IRA, then any IRA early withdrawal you receive will be subject to the 10% penalty tax.
- If you inherit an IRA from a spouse, but you choose to title the IRA as an “inherited IRA,” then you would be eligible to receive IRA early withdrawals without paying the 10% penalty tax.
72(t) Payments
Created by Internal Revenue Code Section 72(t), the Substantially Equal Periodic Payment (SEPP) rule lets account holders withdraw money from their retirement accounts at any age, penalty-free. With 72(t) payments, you withdraw a set amount each year based on your life expectancy. You must follow certain rules and use one of three approved methods to calculate an ongoing withdrawal amount.
You must stick with your withdrawal schedule for a minimum of five years or until you reach age 59 1/2 (whichever event occurs later), or all amounts are withdrawn may be subject to the penalty tax.
Qualified Higher Education Expenses
IRA early withdrawals used to pay qualified higher-education expenses on behalf of you, your spouse, or the children or grandchildren of you or your spouse are exempt from the 10% penalty tax. Funds can be used for room and board (if the student is at least half time), tuition, fees, books, supplies, equipment, and special needs services.
First-Time Home Purchase
Up to $10,000 of an IRA early withdrawal used to buy, build, or rebuild a first home for an ancestor (parent or grandparent), yourself, a spouse, or you or your spouse’s child or grandchild, may be exempt from the 10% penalty tax if you meet the IRS definition of a first-time homebuyer. A first-time homebuyer is someone who hasn’t had an ownership interest in a home in the past two years before you buy a new home.
If both you and your spouse qualify as first-time home buyers, then each of you could withdraw $10,000 from each of your respective IRAs without paying the 10% penalty.
The distribution must be used to pay qualified acquisition costs (which includes reasonable closing costs) before the close of the 120th day after the day you received it.
Rick is a financial coach with a passion for teaching people how to manage their money so they are making better decisions and have less stress in their lives. He can be
reached at rick@rightpath-fc.com.
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