Self-directed IRAs are intended to be used as a savings and investment vehicle for retirement, but many of us have good reason to tap into that resource before we retire. If you withdraw assets from your IRA before you reach age 59½, you could owe the IRS a 10% early distribution tax on top of regular income tax on any IRA distribution of taxable assets. There are, however, several exceptions to this additional 10% tax. One of these may apply to your situation and in most cases is something you simply explain on your tax return. If you haven’t reached 59½ yet, and are thinking about withdrawing from your IRA, here a few ways you could qualify for a penalty-free withdrawal.
Wait Until the End of the Year
The IRS applies the age 59½ rule based on the date that is exactly 6 months following your 59th birthday. If you turn 59 by June 20, wait for six months and one day after your 59th birthday and you can take a penalty-free withdrawal on December 21—the same year you turned 59.
Take From Your Roth IRA
Even if you are not yet eligible to take a qualified distribution from your Roth IRA, you can take tax and penalty-free distributions. Since you paid tax on the money you contributed to a Roth IRA before it went into the IRA, there is no tax assessed when it comes out. And your after-tax contributions are deemed to be the first assets distributed from your Roth IRA. So, you can withdraw as much as you have put in, tax- and penalty-free, at any time. Some investors use this savings and investment strategy to help pay for big expenses before retirement, like college and weddings.
Have an Approved Expense
The tax code allows IRA owners to take penalty-free withdrawals in certain financial instances. If you need to pay for one of the following types of expenses before you reach 59½, you could avoid the 10% penalty tax.
- Healthcare costs: Unreimbursed medical expenses that exceeded 7.5% of your adjusted gross income for the year
- Health insurance: After receiving unemployment compensation for 12 consecutive weeks
- Birth or adoption expenses: Each parent can withdraw up to $5,000 from their own IRA within 1 year of the birth/adoption (cannot be adoption of a step-child)
- First-time home purchase: Lifetime limit of $10,000; the homeowners cannot have had a present interest in a principal residence for two years prior to the date of acquisition; may be used for a child or grandchild’s first home
- Education expenses: Qualified higher education expenses for yourself, a spouse, child, or grandchild
- Disability: being totally and permanently disabled (unable to engage in substantial gainful activity because of physical or mental impairment that is expected to be of long duration)
Commit to a Series of Payments
Another way to avoid the 10% penalty tax is to take equal periodic payments (also known as “72(t) payments” for the section of the tax code governing this exception). To qualify for penalty withdrawals before age 59½, you must commit to taking a certain dollar amount out of your IRA – no more, no less – each year for the longer of five years or until you reach age 59½. For example, if you start payments at age 53, you would continue payments though the year you reach 59½. If you start payments at 57, you would continue payments through the year you reach 62. The IRS has pre-approved three methods of calculating these annual payments:
- Required Minimum Distribution (RMD): Using an IRS life expectancy table, you’ll find a life expectancy factor for your age each year. Divide your account balance by that factor to calculate the amount that you must distribute each year. The payment amount will change from year to year based on investment gains and losses in your IRA.
- Amortization: This method will calculate payments like a loan payment schedule. Your account balance at the start of the payment schedule will be amortized over your life expectancy, using an acceptable interest rate. The payment amount stays the same each year.
- Annuitization: This method is similar to life annuity payout amounts determined by an insurance company. Your account balance at the start of the payment schedule will be annuitized using an acceptable interest rate and annuity factor. The payment amount stays the same each year.
To determine your 72(t) payment amounts, try our 72(t) Calculator.
In addition to taking only the exact payment from your IRA each year, you cannot contribute to the IRA during the arrangement, transfer, or rollover into or out of that IRA. If the arrangement is modified or stopped before the end of the required payment period, you lose the exception to the 10% early distribution tax and will owe the tax retroactively for each year the arrangement was in place, plus interest. An exception applies if you become disabled or pass away, or if the IRA is depleted due to investment losses.
Talk to an Expert
There are several ways to withdraw from your IRA penalty-free before you reach 59½ years old. If you need to tap into your IRA early, speak with your financial advisor to ensure that you are taking the best course of action for your financial circumstances. For more details on taking early distributions from your IRA, visit our FAQ section.
If you are considering opening a self-directed IRA, contact our self-directed IRA experts to learn more about this tax-advantaged account and see if it is the right fit for your retirement portfolio.