Article | December 20, 2023

by Horty & Horty, P.A.

Most distributions from tax-advantaged retirement plans taken before the age of 59 ½ are not just subject to regular income tax but also an additional 10% early withdrawal penalty. And early withdrawals from a SIMPLE IRA may be subject to a heftier 25% penalty if made within the first two years of participation. 

While the rules may seem daunting, especially if you find yourself in a financial bind, there are circumstances where these penalties can be avoided. 

Penalty-free exceptions available to most types of retirement accounts

Some situations enable penalty-free withdrawals from a wide range of retirement plans, including qualified plans, IRAs, SEP, SIMPLE IRAs, and SARSEPs. Before delving into these exceptions, it’s important to note that you should always consult with an expert advisor to ensure you understand the specific rules of your plan and the tax implications of any distribution. 

The following penalty-free withdrawal scenarios have been part of retirement planning for some time and are generally well-known: 

  • After the death of a participant: when a retirement plan participant passes away, beneficiaries are often allowed to withdraw funds from the account without facing the early withdrawal penalty. 

  • Total and permanent disability: participants facing total and permanent disability can access their retirement funds without penalty. There are specific criteria that must be met, and appropriate documentation is required to qualify for this exception. 

  • Series of substantially equal periodic payments (SEPP): SEPP allows for penalty-free withdrawals from retirement plans, but it requires a commitment to take periodic payments based on IRS calculations. These payments must continue for five years or until the participant reaches age 59 1/2, whichever is longer. It’s a complex area, and getting the calculation wrong can result in penalties, making professional guidance essential. 

  • IRS levy of the plan: if the IRS levies your retirement plan for unpaid taxes, any amounts withdrawn because of the levy are not subject to the penalty. This is a straightforward exception, but it’s a situation most plan participants would prefer to avoid. 

  • Unreimbursed medical expenses: participants can withdraw funds penalty-free to cover unreimbursed medical expenses that exceed 7.5% of their adjusted gross income (AGI) or 10% of their AGI if they are younger than 65.

  • Qualified military reservists: military reservists called to active duty may also have access to their retirement funds without penalty. 

  • In-plan Roth rollovers: penalty-free withdrawals are also possible in the context of in-plan Roth rollovers or if the distribution is contributed to another retirement plan or IRA within 60 days. 

New provisions established by the SECURE Act 2.0

The 2022 SECURE Act 2.0 marked a significant expander of the circumstances under which penalty-free withdrawals are allowed. However, it’s crucial to understand that these changes are not all implemented simultaneously. The rollout of these provisions is staggered, with different components becoming effective at various times. 

Victims of domestic abuse

Starting January 1, 2024, self-certifying victims of domestic abuse can withdraw up to $10,000 or half of their retirement account balance, whichever is less, without penalty. 

Federally declared disasters

For victims of federally declared disasters, up to $22,000 can be withdrawn penalty-free from a qualified plan or IRA. Employers can also increase the amount these participants can borrow from their plan. This distribution is taxable as income but is spread over three years. This exception applies retroactively to disasters declared on or after January 26, 2021. 

Terminal illness

Withdrawals for individuals with a terminal illness are exempt from penalty. 

Long-term care insurance premiums

Starting in late 2025, up to $2,500 can be used from retirement accounts to pay for long-term care insurance premiums annually without incurring the 10% penalty. 

Penalty-free withdrawals exclusive to qualifying plans

There are additional exceptions available to those with qualifying plans. Qualifying plans typically refer to employer-sponsored retirement plans. While 401(k)s are the most well-known, there are several other types of qualifying plans, such as 403(b) plans, 457 plans, and Thrift Savings Plans.

Withdrawals pursuant to a Qualified Domestic Relations Order (QDRO)

In the event of a divorce, a QDRO can grant a portion of a retirement plan’s assets to an alternate payee, who is usually the ex-spouse or children. This legal order allows for the distribution of retirement plan assets to the alternate payee without the standard 10% penalty. 

Dividend pass-through from an ESOP

Employee stock ownership plans (ESOPs) may not be viewed as a retirement account in the traditional sense like a 401(k), but they can be part of an individual’s retirement plan portfolio and are subject to specific rules similar to those governing traditional retirement plans.

Some ESOPs may have a unique feature where employees can receive dividends on the company stock held within the ESOP. These dividends can be passed through to the employee and, under certain conditions, can be withdrawn without penalty. However, the rules governing these distributions can be complex, so it is essential to understand the specific conditions under which these withdrawals are permitted. 

Separation from service

One of the lesser-known exceptions to the early withdrawal penalty is the age 55 exception. If an employee separates from service (leaves their job) during or after the year they reach age 55, they can withdraw funds from their qualifying plan without penalty. For public safety employees, such as police officers and firefighters, the age threshold for penalty-free withdrawals is even lower, at age 50. 

Penalty-free withdrawals exclusive to non-qualifying plans

In addition to qualifying plans like 401(k)s, there are specific situations where penalty-free withdrawals are permitted from IRA, SEP, SIMPLE IRA, and SARSEP plans. These plans, while different in their structure and contribution limits, also offer exceptions to the early withdrawal penalty under certain conditions. 

Qualified Higher Education Expenses

Individuals can withdraw funds from these plans without penalty to pay for qualified higher education expenses for themselves, their spouse, children, or grandchildren. This includes tuition, fees, books, and certain room and board costs. 

First-Time Homebuyer Exception

This provision allows individuals to withdraw up to $10,000 from their IRA plans to purchase a first home without incurring the early withdrawal penalty. The IRS defines a first-time homebuyer as someone who hasn’t owned a principal residence in the past two years. Notably, if both spouses are first-time homebuyers, they can each withdraw $10,000, potentially contributing $20,000 towards their home. This amount can also be used towards purchasing a first home for their children, grandchildren, or parents.

Health Insurance Premiums During Unemployment

For those who are unemployed, IRA plans allow the withdrawal of funds to pay for health insurance premiums without the 10% penalty. 

New Child or Adoption

IRA plans permit penalty-free withdrawals of up to $5,000 for the birth or adoption of a child. This exception is applicable per parent, meaning two parents could potentially withdraw $10,000 collectively. Unlike some hardship exceptions, these funds can be used for any expenses following the birth or adoption and are not limited to specific costs related to these events.

This article is intended to provide an overview of circumstances where early withdrawal penalties may be circumvented. However, it’s important to note this article does not delve into the minute details of each provision. It’s important to consult with a financial expert before making any decisions about early withdrawals. An expert can offer personalized guidance and ensure you fully understand all possible implications, including tax consequences and the impact on your long-term goals. For more information, please contact our office.

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