One issue with investing money in a 401k or IRA is that you generally cannot access the funds until you reach age 59½.  If you withdraw funds from these retirement accounts before that age, you will be subject to a 10% penalty on the amount distributed.  This penalty is in addition to the federal and state income taxes you’ll pay on the distribution.

Fortunately, the IRS will waive the 10% penalty in certain circumstances.  However, even if you meet one of these exceptions, you’ll still have to pay federal and state income taxes on the distribution even if the 10% penalty is waived.

The exceptions are:

• Distributed funds that are rolled over into an IRA or other qualified plan
• Distributions upon death or disability of the account owner
• Distributions that are part of a series of substantially equal periods payments over the life of the account owner or the joint lives of the participant and beneficiary
  • Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity).  These annuity payments are exempt from the 10% penalty.  The annuity has to last through the later of:
    • When the account owner turns 59½
    • Five years after the date annuity payments began
• Distributions after the participant’s separation from service (i.e., quitting/laid off/fired), provided the separation from service occurred during or after the year the participant reached age 55 (or age 50 for government plans to a retired police officer, firefighter, or emergency medical services provider).
  • This exception applies only to qualified plans, it does NOT apply to IRAs
• Distributions to a former spouse under a Qualified Domestic Relations Order (QDRO)
  • Pension benefits are often divided during divorce.  To properly comply with pension plan rules, retirement accounts can only be split up pursuant to a QDRO.  Otherwise, the plan will have made a disallowed distribution to a nonparticipant.  This could jeopardize the tax-advantaged status of the pension plan.
  • Once a retirement account has been divided pursuant to a QDRO, the nonparticipant spouse can receive distributions without incurring the 10% penalty.  However, the nonparticipant spouse is still subject to the pension plan rules and isn’t entitled to any type or form of benefits that aren’t available in the plan.
  • IRAs do not require QDROs to be divided in divorce.  The division of the IRA does not cause a distribution; however, amounts withdrawn from the IRAs by either spouse will not be exempt from the 10% penalty if it is a disqualifying distribution.
• Distributions to the extent of deductible medical expenses
  • Medical expenses are reduced by 7.5% of adjusted gross income to arrive at deductible medical expenses.  Early distributions equal to this amount can be distributed free of penalty.
• Distributions made on account of the IRS’ levy of retirement accounts

The following exceptions apply only for IRAs:

• Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks.  The reduction for 7.5% of adjusted gross income does not apply.
• Distributions used to pay for qualified higher education expenses (college) for the account owner, owner’s spouse or child/grandchild.
• Distributions up to $10,000 for first time homebuyers.
  • “First time” doesn’t literally mean “first time.”
  • First time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230..