Exceptions to the 10% IRA Early Distribution Penalty – Updated for Covid-19
We’re not going to sugarcoat it: 2020 was a tough year. Even the best budgeters and savers found themselves struggling, and many had no choice but to dip into their retirement funds just to survive.
Ordinarily, taking early distributions from your retirement plan means paying hefty fees and penalties at tax time. But there’s nothing ordinary about 2020, and the federal government knows it. This year, the tax man is being a bit more generous about early retirement account withdrawals, which could save you lots of money on April 15.
What is the IRA Early Withdrawal Penalty?
To encourage people to save for their retirement, the IRS gives taxpayers a tax break when they contribute to a traditional IRA. In return, they expect taxpayers to keep the money in the bank until they reach a certain age.
Unfortunately, life sometimes has other plans. Sometimes people have financial issues that make it necessary for them to use some of their retirement money now. If you need to pull money out of your account before reaching the age of 59 1/2, expect to pay the tax on it along with a 10 percent early withdrawal penalty.
This is why financial planners often advise their clients to take early distributions from retirement accounts only as an absolute last resort. You can do it, but it’ll cost you in multiple ways. Obviously, the tax penalty can hurt. But you’re also reducing the amount of money you’ll have in retirement and missing out on the interest that would have continued accruing on your money. There can be a lot to lose, so weigh your decision carefully.
What Reasons Can You Withdraw from an IRA Without Penalty?
Ultimately, pulling retirement money early will cost you in one way or another, but there are a few ways to reduce the sting. Even before COVID-19, the IRS would allow taxpayers to pull retirement money penalty free if they did so for specific reasons.
One of those reasons is healthcare. If you have medical expenses that exceed 7.5 percent of your adjusted gross income, you can use money in your retirement account to pay those bills without paying a penalty. Taxpayers who lose their health benefits can also use money from the IRA to purchase their own health insurance. You can also pull retirement funds without penalty if you become permanently disabled and unable to continue working.
Higher Education & Military Deployment
Putting yourself, your spouse or your child through college? The IRS won’t penalize you if you withdraw IRA money to pay for higher education expenses. Military reservists and National Guard members called to active duty may also access retirement funds without repercussions.
First Time Home Buying
The same is true if you’re a first-time homebuyer or need to pay an IRS levy. If you inherit an IRA from anyone other than your spouse, you may choose to keep the money without a tax penalty as well — you don’t have to roll it into another IRA if you don’t wish to do so.
Substantially Equal Periodic Payments
The IRS also allows taxpayers to take equal payments from their retirement accounts for five years without penalty. To do so, you must use the IRS worksheet to determine how much money you’re eligible to take. You will then receive a payment once a year for five years or until you reach 59 1/2 years of age, whichever comes first. This strategy is known as Substantially Equal Periodic Payments or SEPPs.
Be aware that although you can take free withdrawals for any of these reasons, the burden of proof is always on you. When you request your funds, your plan administrator is allowed to ask for proof of your situation before signing off on a penalty free withdrawal. They are allowed and often expected to do so.
COVID-19 Special Exemptions
To help struggling families navigate the financial landmines of the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief and Economic Security Act (CARES Act). This greatly expands the number of people who can make early IRA withdrawals without penalty and requires them to offer little if any proof of their situation.
According to the new rules, you can make a withdrawal without paying the 10 percent penalty if your finances took a hit because you contracted COVID, were quarantined or got furloughed. You also qualify if COVID reduced your work hours, cost you your job, or prevented you from working due to a lack of child care. If you had a job offer rescinded or had to delay the start of a new job due to the virus, you also qualify to make early withdrawals, as do small business owners who had to close. You also qualify if your spouse meets any of these conditions.
Although the CARES act is quite generous in its scope, it does restrict the types of qualified retirement plans from which you can withdraw. The account must be one of the following, an:
You are also required to take your distribution in 2020 to be eligible and the IRS limits the amount you can take. You may pull from one account or several, but the amount you take in total may not exceed $100,000. If you take more, you will have to pay the penalty on any money in excess of the $100,000 threshold.
Note that even if you don’t have to pay a penalty on these withdrawals, you may still have to pay income tax on them. In a traditional IRA, you get a tax break on any money you deposit in the account. You must then pay taxes on the money when you withdraw it. The CARES Act doesn’t change this.
You are, however, allowed to spread the income from your IRA distribution over a period of three years. If you withdrew $30,000 from your account, for example, you can claim it all in one year and pay the tax due or you can report $10,000 worth of income every year for the next three years (2020, 2021 and 2022). This allows you to spread out your tax payments.
It’s important to remember that you’re also allowed to pay yourself back. Again, let’s say you withdrew $30,000 from your retirement account in May of 2020 expecting a rough summer. You got an unexpected bonus as an essential worker, however, and didn’t need the money after all. If you put the money back in your IRA before filing your tax return in April of 2021, you don’t have to report the money as income.
If you pay yourself back after you’ve already reported the income, you can amend your return. So long as you’re in the three-year reporting period, you may redeposit your money back into your IRA and then file an amended return to recover any taxes you paid on your withdrawal. You can do this with partial payments as well. If you withdrew $30,000 but were able to put $15,000 back into your retirement account, you can reflect that on your tax return to help limit your tax liability.
Get Professional Tax Help
It’s been a rough year for all of us, and at Picnic Tax Solutions we’re eager to do what we can to help. We may not be able to cure COVID, but we can certainly help you understand how it has affected your tax picture and help you plan a good strategy for moving forward.
If you’re overwhelmed by trying to figure out whether you owe taxes, penalties or both, we’re here to help. Find a CPA and together we’ll sort through the chaos of 2020 and get things organized again.