4 Strategies to Avoid Paying a Penalty for Early IRA Withdrawals

Retirement accounts are a great way to save for the future, but if you withdraw money from them before you retire, you may have to pay a penalty.

The tax code waives the penalty for early withdrawal in some circumstances, and federal lawmakers are about to add a few more. For example, people who need money in the event of terminal illness, domestic abuse, natural disaster or another financial emergency will not be penalized for early withdrawal.

Among a host of retirement reforms known as "Secure 2.0," President Joe Biden is set to sign into law a change as part of a $1.7 trillion federal spending package. Last week, Congress passed the legislation.

Financial experts have advised Americans to avoid withdrawing money from their retirement accounts early, even though the rules have been loosened. This is because doing so can have negative consequences on your future financial security.

Starting in 2024, you'll be able to roll over funds from your 529 plan to a Roth IRA without paying any taxes. This could be a great way to save for retirement if you're able to take advantage of the tax-free growth.

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"Taking money from your retirement account before you're supposed to can have serious consequences," said Ed Slott, a certified public accountant and IRA expert based in Rockville Centre, New York. "I would only do this if it was the last resort and this was the only money you had."

If you withdraw money from a retirement account before you turn 59½, you'll generally have to pay a 10% penalty on top of any income taxes that are due.

The new legislative package waives the 10% early withdrawal penalty for IRA owners and applies to savers with a workplace retirement plans like a 401(k).A person who is terminally ill would not be penalized for withdrawing retirement funds before age 59½.

The law defines "terminally ill" as an illness or physical condition that is expected to result in death within 84 months of a physician's assessment.

The rule will go into effect once the new law is enacted.

Victims of domestic abuse will be able to withdraw up to $10,000 from their retirement accounts within a year of the incident, under a new rule that takes effect in 2024.

Individuals may need to access that money to help escape an unsafe situation, for example, as the Senate Finance Committee said in a summary document.

Domestic abuse is defined as any type of physical, psychological, sexual, emotional, or economic abuse that is used to control, isolate, humiliate, or intimidate a victim. This can also include any attempts to undermine the victim’s ability to reason independently, such as through the abuse of a child or another family member living in the same household.

The victim is able to withdraw $10,000 or 50% of their account balance, whichever is less. This amount will be adjusted according to inflation.

Starting in 2024, taxpayers will not be penalized for withdrawing retirement funds for certain emergency expenses. These expenses must be "unforeseeable or immediate" and related to personal or family emergencies.

Savers can make one financial emergency withdrawal of up to $1,000 a year. However, they can't take an additional withdrawal within three years unless they repay the initial distribution or make regular deposits that at least match the withdrawn amount.

Savers can withdraw up to $22,000 from their retirement accounts without penalty in the case of a federally declared disaster.

The federal government sometimes issues one-off waivers associated with certain disasters, but the new law entrenches a permanent rule. This means that going forward, the government will have a set process in place for issuing waivers in the event of a disaster. This will provide much-needed stability and predictability in the wake of a disaster.

The distribution is penalty-free and the funds can be counted as gross income over three years instead of one. The distribution can also be repaid to the retirement account.

There are several existing exceptions in the tax code for those under 59½. In addition to these, there are new rules that may apply.

You may be exempt from the penalty if you use IRA funds to pay for qualifying higher-education costs for yourself, your spouse, or your children or grandchildren.

Eligible costs for financial aid include tuition, fees, books, supplies, and equipment required for a student’s enrollment or attendance. Room and board also qualify for students who attend school at least half-time. Special-needs services may also be covered by financial aid.

To be eligible for federal student aid, students must attend an accredited college, university, vocational school or other institution that participates in the U.S. Department of Education's student aid programs. This includes most accredited public, nonprofit and privately owned for-profit institutions, according to the IRS.

Although the name suggests otherwise, you don't have to be a first-time home buyer to take advantage of this exception. The IRS generally defines a first-time buyer as someone who hasn't owned a home in the last two years.

IRA owners can withdraw up to $10,000 without being penalized. This is the maximum amount allowed lifetime.

The funds can be used for buying, building or rebuilding a home, or for “any usual or reasonable settlement, financing, or other closing costs,” according to the IRS. The money must be used within 120 days of receipt.

The IRA withdrawal can be used for you, a spouse or your child, among other qualifying family members. If both you and your spouse are first-time homebuyers, each can take distributions up to $10,000 without penalty.

The two-year limitation period for claiming a homebuyers' rebate begins on the "date of acquisition": the day on which you enter into a binding contract to buy, or on which the building or rebuilding begins.

If you lost your job, you may not be subject to a penalty if you receive distributions to cover health insurance premiums for you, a spouse and dependents.

To qualify for this withdrawal, you must have received unemployment compensation for 12 consecutive weeks. The withdrawal must also occur in the year you received unemployment, or in the following year. Further, you must take the withdrawal within 60 days of being reemployed.

Beneficiaries who inherit an IRA from the owner generally aren't subject to a penalty if they pull money from the account before age 59½.A distribution from a health savings account (HSA) to cover medical costs is not subject to penalty.

The exception applies to unreimbursed medical expenses that exceed 7.5% of your annual adjusted gross income. The applicable income is that during the year of withdrawal.

For example, if your AGI is $100,000 in 2022, you can use a withdrawal this year to cover unreimbursed medical expenses that exceed $7,500.

You can still get the benefit even if you take the standard deduction. You don't need to itemize tax deductions to get this benefit.

Slott warned against one potential end-of-year problem. If you put a medical bill on your credit card this week or next, that medical expense would count for the 2022 tax year - even if the credit-card bill itself isn't paid until 2023.

This means that an IRA withdrawal linked to that medical expense would have to occur in 2022, not 2023, to get the tax benefit.

Parents can use up to $5,000 from their retirement accounts to cover expenses associated with a birth or adoption.

You must make the account withdrawal within a year of your child's birth or the date on which the legal adoption of your child was finalized.

Retirement savers who are disabled and under the age of 59½ are not subject to the tax penalty.

To qualify for the disability tax credit, an individual must be “totally and permanently disabled.” The IRS defines this as being unable to do “any substantial gainful activity” because of physical or mental condition. A physician must certify the condition “can be expected to result in death or to be of long, continued, and indefinite duration.”

It can be difficult to meet the requirements for a medically-based definition of disability, according to Slott. In general, an individual must be unable to work due to a serious health condition or be confined to a bed.

If the distribution of your retirement funds is a result of an IRS tax levy, you will not be penalized.

Reservists in the Army, Navy, Marine Corps, Air Force, Coast Guard or Public Health Service may be exempt from penalty. This exemption may apply if the reservist is called to active duty for more than 30 days.

Individuals who were ordered or called to active duty after September 11, 2001, and who served for 180 days or more, or for an indefinite period, are eligible for this benefit.

The account distribution cannot be made earlier than the date of the call to active duty and no later than the close of the active-duty period.

The exemption for IRA owners is "very complicated" and likely requires the help of an accountant or advisor, Slott said.

A taxpayer can avoid a penalty by making periodic account distributions (at least one per year). These "substantially equal periodic payments" are like an annuity, and are also known as 72(t) payments.

Determining the right amount to withdraw from savings is just one part of the equation – savers must also stick to a schedule until age 59½ to avoid any errors, Slott said.

Making a mistake with your tax withholding can be expensive. If you take the wrong amount out one year, for example, you would void the exception and owe the 10% penalty for each year of withdrawals that have already occurred.

"I think it's a very harsh penalty," Slott said.