When are IRA withdrawals penalty-free?

Many IRA owners are aware they can be hit hard with penalty fees if they withdraw money from their accounts early. IRA owners should make every effort to avoid taking money out of their retirement accounts early, especially if you are young. 

By withdrawing money, you are losing decades of tax-free compounding which, depending on your investment, could cost you tens of thousands and possibly hundreds of thousands of dollars by the time you retire. Here are some ways to avoid that penalty on early distributions:

• Permanent disability of IRA owner. Money can be withdrawn without penalty in the event the IRA holder becomes permanently disabled before age 59½. A physician must determine that, because of mental or physical disability, you are unable to engage in any gainful employment.

• Death of IRA owner. If you die before you’re 59½ years old, your estate and beneficiaries won’t be hit with the 10-percent penalty. But if a spouse inherits the IRA and elects to treat it as his or her own, it may become subject to the 10-percent penalty if money is withdrawn before he or she is 59½.

• First-home purchase. Once in a lifetime, you can take a penalty-free IRA distribution of up to $10,000 ($20,000 for couples) to buy or build the first home of you or your spouse’s child, grandchild or parent. According to the IRA rules, you are a first-time buyer if you did not own a home in the last two years. If the anticipated purchase is canceled, put the money back into the IRA within 120 days of the distribution to avoid the penalty.

• Withdrawals used to help pay unreimbursed medical expenses. In the event of serious illness or injury, Uncle Sam will waive the early withdrawal fee on the condition that the expenses are in excess of 7.5 percent of your adjusted gross income. The distribution has to be in the same year as the medical expense.

For example, if your adjusted gross income (AGI) is $80,000 and your unreimbursed medical expenses are $10,000, the maximum amount you can distribute penalty-free is $4,000, which is the difference between $10,000 and 7.5 percent of your AGI ($80,000).

• Higher-education costs. Higher-education costs for you, your spouse, children or grandchildren can be withdrawn penalty-free. Spending the money on tuition, fees and books will get you a penalty exemption. Room and board also count if the individual attending college is at least a half-time student. Qualifying institutions include colleges, universities, and vocational schools.

• IRS tax levy. Money taken from an IRA and used to pay back taxes will not be penalized. Note the exception does not apply if you voluntarily withdraw the amount from your IRA to pay the taxes in order to avoid the levy.

• Withdrawals used to pay medical-insurance premiums. Out of a job? You won’t be penalized for using IRA retirement money to pay your medical-insurance premiums as long as you have been on unemployment for longer than 12 consecutive weeks.

• Set up an annuity. You can set up a series of annuity payments from your IRA without incurring the early-withdrawal penalty. You must use an IRS-approved distribution method and take at least one withdrawal annually to avoid the penalty. The payments are based on life expectancies; and generally require professional assistance to calculate

• Owe the IRS. If the IRS comes knocking on the door, he doesn't care where the money comes from as long as you pay it. You are allowed to take the money penalty-free to settle your tax debt.

• IRA owner turns 59½. Once you have reached the qualifying age, you can make penalty-free regular withdrawals upon which to live.

Even though amounts distributed for the above reasons are excused from the early-distribution penalty, they may still be subject to Federal and state tax. To claim the early-distribution penalty exception, you may be required to file IRS Form 5329 along with your tax return

Barry Lisak is an IRS enrolled agent specializing in personal and small business taxes for 30 years. Any questions can be directed to him at 516-829-7283, or mrbarrytax@aol.com.