IRAs and other retirement accounts are really designed—as the name says—for retirement. But in these times, there are circumstances that dictate the need to take out those funds early. And taking money out of IRAs should be your last resort, since distributions can come with a heavy tax penalty if you take them out early, but sometimes you just have no choice.
There is a 10 percent penalty, correct?
Right. So not only is there that 10 percent penalty if you take it out early, but you also have to pay federal and state income tax. So you know, it could be a pretty good dollar of tax that you have to pay by taking it out early.
Are there ways to avoid the penalty?
There is. If you’re over 59 ½, you can take money out of your IRA at any time without any issues. And there’s also a number of exceptions—some are old and some are new.
What are the exceptions to the rule?
So some of the ones that have been around for a while are things like:
- A first-time homebuyer. A first-time homebuyer can take up to $10,000 out and not have to pay the penalty. They still have to pay the tax, but not the penalty. And it’s interesting, because the way the IRS defines “first-time homebuyer” is it’s someone who hasn’t owned a home in the last two years. So you could technically, in the IRS’ eyes, be a “first-time homebuyer” multiple times during your lifetime.
- And then you can also use it for qualified education expenses—for tuition, fees, books, those kinds of things.
- You can use it to pay health insurance if you’re unemployed (only if you’re unemployed).
- You can also take it out if you’re disabled. Now this one is not a very easy hurdle to meet, because there are very strict requirements on the disability part.
- But also if you have medical expenses that are deductible, which means that they’re above that threshold that the IRS says.
- And any tax levies—so not tax debt, only tax levies. The IRS actually has to have levied you in order for those IRA distributions to not be penalty-free.
You also mentioned there is a new one …?
There is. So with the Coronavirus Aid, Relief, and Economic Security (CARES) Act this year, they actually said that if you have a child (either born or adopted), as long as [it’s] within the first year of the date of birth or when the adoption is finalized, you can take out up to $5,000 per child without having to pay the penalty.
Don’t they usually withhold taxes on distributions …?
They do, but it’s normally not enough to cover the tax and the penalty, so be careful. Don’t assume that that withholding is going to be enough. You may still owe a little bit more when you file your tax return.
Now this is an IRA. Like a 401(k), can you take out a loan from the IRA?
You cannot. So unlike 401(k)s like you said, there are no loan provisions in an IRA. Now, there is a way that you can take it out and spread the tax over three years, but it’s not a loan.
One last question: If you take a distribution, can you change your mind and put it back?
You can, as long as you do it within 60 days of when you took it out, you can put it back in.
More Podcasts About IRAs:
- The Tax Impact on Receiving an Inheritance
- The Ins and Outs of Inherited IRAs
- To Gift or Not To Gift