Can You Avoid the 10 Percent IRS Penalty on Early Retirement Plan Withdrawals?

Most of us assume that the Internal Revenue Service rarely does us any favors, and that assumption is accurate, most of the time. However, the IRS does, on occasion, forego its “tithe” from funds that would otherwise be subject to either taxation or even an added penalty. Specifically, there are certain exceptions to the all-too-familiar penalty for early withdrawals from IRAs and other tax-qualified plans. But you have to be careful, and you must pay meticulous attention to the details in order to avoid getting dinged by a penalty you thought you were exempted from.

Typically, any withdrawal from an IRA, 401(k) plan, 403(b) plan, or other tax-qualified plan that occurs before age 59 ½ is subject to taxation as ordinary income and an additional 10% penalty. The object of this rule, of course, is to encourage taxpayers to leave these funds alone and allow them to do what they were intended to do: provide for a more financially secure retirement. But many do not know that the U.S. Internal Revenue Code allows exemptions from the 10% penalty under certain circumstances. However, the exceptions differ, depending on the type of plan the funds are being withdrawn from; the rules are different for IRAs, 401(k) plans, and 403(b) plans. Not only that, but certain requirements apply to each exception, and if these aren’t carefully observed, taxpayers who thought they didn’t owe the 10% penalty can learn to their chagrin that the tax court thinks otherwise.

For example, the death or complete disability of the account owner allows exemption from the 10% penalty for all types of plans—IRAs, and employer plans (401(k) and 403(b)) included. But the exemption for higher education expenses, which can be especially important for younger taxpayers who may be going back to school themselves or paying for a child’s college tuition, applies only to IRAs, not to employer plans. This means that if you have a 401(k) plan, for example, and have decided to go back for more schooling—to get an accounting or teaching degree, perhaps—you would need to first roll over your eligible 401(k) assets to an IRA, and only then could you qualify for the educational-expense exemption from the 10% early withdrawal penalty. Likewise, the exemption for first-time homebuyers applies only to owners of IRA accounts, not employer plans.

Even when you do qualify for certain exemptions, you must pay close attention to IRS requirements for the amount and timing of distributions and expenses, as well as other specifics. For example, distributions from all types of qualified plans—IRAs and employer plans—are permitted for payment of qualified medical expenses. However, in order to be considered qualified, the expenses must meet or exceed the percentage of adjusted gross income (AGI) required for deductibility (10% in 2019). Additionally, the tax courts have held that the withdrawals must be spent in the same year as the expenses were incurred, and that the taxpayer must provide clear proof that the withdrawals were actually expended to pay the medical bills.

If you are considering taking money out of a tax-qualified plan for what you believe is a purpose exempted from the 10% early withdrawal penalty, you should consult with a qualified, professional financial or tax advisor. You might also wish to read the IRS guidelines. But whatever you decide, just remember that, especially where the IRS is concerned, the details really do matter.