Generally, you will want to avoid taking money out of your retirement plan early, or more than six months before you turn 60. In most cases, this will result in a 10 percent penalty that is added to the income tax that you owe on the distributions. If you do need to withdraw money from your retirement plan in an emergency or another unavoidable situation, you should know that there are certain exceptions to this rule.
For example, you can take distributions in equal annual installments across your life. This is known as the substantially equal periodic payment exception. It applies to any IRA but only applies to an employer’s retirement plan if you have left your job before starting to take distributions.
Paying Medical Expenses
You might be able to partly avoid the early distribution penalty if you use the distribution to pay medical expenses that would be deductible on a tax return. The medical expenses must relate to treatment for you or for your spouse or child. You can avoid the penalty only to the extent that the expenses exceed 10 percent (formerly 7.5 percent) of your adjusted gross income. The exception applies regardless of whether you actually itemize the medical expenses as deductible on your return.
Paying Child Support and Alimony
If you are separated or divorced, a Qualified Domestic Relations Order (QDRO) may be in place. This requires an individual to make alimony or child support payments from their retirement plan, and it may require them to distribute benefits from the plan to their ex-spouse as part of dividing property between the spouses. The penalty will not apply to QDRO payments, unless the retirement plan is an IRA.
Employee Stock Ownership Plans
These are stock bonus plans that consist largely of stock in the employer’s company. In some cases, an employee will be able to get cash distributions from this type of plan if the plan gives them the right to have benefits paid in employer stock. The penalty does not apply to distributions of dividends from an ESOP.
Working Until 55 or Older
If you receive distributions from a retirement plan through your former employer, you will need to pay income tax on the distributions but will not incur the additional penalty if you were 55 or older in the year that you left the employer. (This does not mean that you need to be 55 on the date that you left the job, but only that you need to turn 55 at some point in that calendar year.) You can work for a different employer without losing this exception. Also, you can go back to the same employer later. For example, you might start working for the same employer after you reach the age of 59½, when the penalty expires.
Death and Disability
Many people name beneficiaries in their retirement plans so that they can receive benefits from the plan when the person who started the plan dies. The penalty will not apply to distributions made after you die if the account remains in your name at the time of the distribution. If your spouse dies before you, and you are the beneficiary of their plan, you can transfer a distribution from their plan to your plan without paying the penalty.
An exception also applies if you suffer from a disability, but the definition of a disability is unclear. One key point to bear in mind is that the disability must be permanent. Even if it is severe and requires hospitalization, the exception may not apply if the disability is not permanent. The permanency requirement means that the disability needs to be deemed permanent at the time of the distribution. If the disability later is found to be permanent, the exception will not apply retroactively.
Refunds of Contributions
Sometimes an individual with a retirement plan will make a larger contribution than allowed in a certain year. The plan then will refund the excess amount. You should not incur a penalty for the refund, although other taxes and penalties may apply. The plan administrator should make sure to provide the refund before you file your tax return so that you do not incur the penalty.
Specific Exceptions for Traditional IRAs
The penalty exceptions for traditional IRAs are somewhat different. For example, the exceptions for QDRO payments and people who leave their employer at 55 or older do not apply. The refund exception still applies as long as you take out the excess before you file your tax return. However, any income earned on the excess when it was in the account must be withdrawn and will be subject to the penalty.
Traditional IRAs may provide additional exceptions for money used to pay health insurance premiums (if you were unemployed or recently unemployed), expenses for higher education, and the purchase of a first home. You must meet very technical criteria to trigger these exceptions, so you should review the rules carefully to determine whether you can avoid the penalty.