Avoid early withdrawal tax penalties from the Individual Retirement Account

Retirement accounts are a tax-efficient way to build your nest egg, but tapping them too soon usually comes with a penalty.

However, the tax code waives this penalty in certain circumstances. And federal lawmakers are about to add a few more waivers — for example, when people need money for terminal illness, domestic violence, natural disaster or other financial emergency.

The changes are part of a series of pension reforms – collectively known as the “Secure 2.0— that President Joe Biden is set to enact legislation as part of a $1.7 trillion federal spending package. Congress passed the legislation last week.

Americans should try to avoid withdrawing money from retirement accounts early despite looser rules, financial experts have said.

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“The worst thing you can do is take money out of your retirement account before its destination, because then what will be there for your retirement?” Ed Slott, a certified public accountant and IRA expert based in Rockville Center, New York, previously told CNBC. “I would only do this if it was the last resort and it was the only money you had.”

Savers in general incur a 10% tax penalty if they withdraw money from a retirement account before age 59.5. This is in addition to any income tax resulting from the withdrawal.

The following list outlines the rules in the new legislative package that waive the 10% early withdrawal penalty for IRA owners. These measures also apply to savers with a workplace retirement plan such as a 401(k).

1. Terminal illness

A terminally ill person would not be penalized for withdrawing retirement funds before age 59.5.

The law defines “terminally ill” as an illness or physical condition that can reasonably be expected to result in death within 84 months of a physician’s assessment.

The rule comes into force upon promulgation of the new law.

2. Domestic violence

Victims of domestic violence by a spouse or domestic partner can withdraw up to $10,000 in retirement funds within one year of the incident. The rule comes into force in 2024.

Individuals may need access to this money to help escape a dangerous situation, for example, the Senate Finance Committee said in a summary document.

The law defines domestic violence as “physical, psychological, sexual, emotional, or economic abuse, including efforts to control, isolate, humiliate, or intimidate the victim, or to undermine the victim’s ability to reason independently, including including by abusing the victim’s child or another family member living in the household.”

The victim can withdraw the lesser of $10,000 – an amount that will be adjusted upwards for inflation – or 50% of their account balance.

3. Financial emergency

From 2024, taxpayers will no longer be penalized for withdrawing pension funds for certain emergency expenses. These are “unforeseeable or immediate” expenses related to personal or family emergencies.

Investors can make a financial emergency withdrawal of up to $1,000 per year. However, they cannot make an additional withdrawal within three years unless they repay the initial distribution or make regular deposits equal to at least the amount withdrawn.

4. Natural disasters

Savers can withdraw up to $22,000 without penalty in the event of a federally declared disaster.

The federal government sometimes issues one-time waivers associated with certain disasters, but the new law establishes a permanent rule.

Additionally, funds can count as gross income over three years instead of one. Distributions may also be returned to the retirement account.

In addition to the new rules, the tax code has several existing exceptions for those under 59 and a half.

(Note: The first three apply only to IRAs. The others can apply to both IRAs and workplace retirement plans.)

1. Higher education expenditure

You may be exempt from the penalty if IRA funds are used to pay eligible college fees for you, your spouse, or your or your spouse’s children or grandchildren.

Eligible costs include tuition, fees, books, supplies, equipment required for a student’s enrollment or attendance, and expenses for certain special needs services. Room and board are also eligible for students attending school at least half-time.

Students must be attending a college, university, vocational school, or other institution that can participate in U.S. Department of Education student aid programs. (These include accredited, public, nonprofit, and private for-profit institutions, according to the IRS.)

2. First-time home buyer

Contrary to what the IRS title might suggest, IRA owners do not have to be first-time home buyers to qualify for this exception. The IRS generally defines a first-time buyer as someone who hasn’t owned a home in the past two years.

These IRA owners can withdraw up to $10,000 without penalty. This monetary threshold is a lifetime maximum.

Funds must be used for “qualified acquisition costs”. These are: the costs of buying, building, or rebuilding a home, and “any customary or reasonable settlement, financing, or other closing costs,” according to the IRS. Money must be used within 120 days of receipt.

The IRA withdrawal can be used for you, a spouse, or your child, among other eligible family members. If you and your spouse are both first-time homebuyers, each can accept distributions of up to $10,000 without penalty.

The two-year limitation period begins on the “acquisition date”: the day you enter into a firm purchase agreement or the day construction or reconstruction begins.

3. Health insurance if unemployed

Distributions to cover health insurance premiums for you, your spouse and your dependents may not be subject to a penalty if you have lost your job.

To qualify, you must have received unemployment compensation (through a federal or state program) for 12 consecutive weeks. The IRA withdrawal must also occur in the year you received unemployment or the year after. In addition, you must take the withdrawal within 60 days of your re-employment.

4. Death

Beneficiaries who inherit an IRA on the death of the owner are generally not subject to a penalty if they withdraw money from the inherited account before age 59½.

5. Unreimbursed medical expenses

A distribution to cover medical expenses cannot be punished.

The exception applies to unreimbursed medical expenses that exceed 7.5% of your annual adjusted gross income. The applicable income is that of the year of withdrawal.

For example, if your AGI is $100,000 in 2022, you can use a withdrawal that year to cover unreimbursed medical expenses over $7,500.

You do not need to itemize tax deductions to receive this benefit. (In other words, you can still get it if you take the standard deduction.)

Slott warned of a year-end problem. If you put a medical bill on your credit card this week or next week, those medical bills will count for the 2022 tax year — even if the credit card bill itself isn’t paid until 2023.

This means that an IRA withdrawal related to these medical expenses would need to occur in 2022, not 2023, to receive the tax benefit.

6. Birth or adoption

Each parent can use up to $5,000 per birth or adoption from their respective retirement accounts. The funds would cover associated expenses.

Account withdrawal must be made within one year of your child’s birth or the date your child’s legal adoption was finalized.

7. Disability

Certain disabled savers under the age of 59.5 are not liable for the penalty tax.

To qualify, they must be “totally and permanently disabled”. The IRS defines this as being unable to do “any substantial gainful activity” due to physical or mental condition. A physician must certify that the condition “may result in death or be of long, continuous, and indefinite duration.”

Overall, it’s a rigid definition that’s hard to stick to, Slott said. In practice, someone usually has to be near death or bedridden and unable to work, he said.

8. Tax levy

You will not incur a penalty if the distribution results from an IRS tax levy (i.e. if the IRS takes your retirement funds to settle a tax liability).

9. Active Reservists

Army, Navy, Marine Corps, Air Force, Coast Guard, or Public Health Service reservists may be exempt from penalties.

They must have been commissioned or called into active service after September 11, 2001 and in service for 180 days or more or for an indefinite period.

Their accounting distribution cannot be made before the date of recall to active service and at the latest at the end of the period of active service.

10. Substantially Equal Periodic Payments

This exemption for IRA owners is “very complicated” and likely requires the help of an accountant or advisor, Slott said.

Simply put, a taxpayer can avoid a penalty by sticking to a formula that describes an amount of periodic account distributions (at least one per year). These “substantially equal periodic payments” are like an annuity and are also known as 72