If you're not careful, you may get dinged by a 10% penalty for withdrawing money from your IRA before you reach the age of 59-1/2. Just like most things in government, however, there are exceptions to every rule. The IRS allows you to make early withdrawals without penalty for a few different reasons. Here are five.
In the event you are unemployed, you could make penalty-free early withdrawals from your IRA as long as they ONLY go toward paying for health insurance. However, for this penalty-free privilege, you would need to have collected unemployment benefits for 12 weeks in a row. This is by no means the ideal way to draw down your retirement nest egg, but nonetheless is something to be aware of.
Let's say that, after a hospital visit, you find out that your health insurer won't cover all of expenses related to your stay. You would be able to make an early withdrawal from your IRA to cover this shortfall without getting penalized. However, two conditions must be met: The withdrawal must only go toward this shortfall, and the amount not covered by your health insurer must be greater than 10% of your adjusted gross income.
If you are disabled (physically or mentally) and are unable to work, you might be eligible to make unlimited early withdrawals from an IRA without penalty. You would have to satisfy the IRS's definition of being disabled, and demonstrate through a doctor's opinion that you are permanently unable to work in your current capacity.
Early withdrawals from an IRA that go toward a first-time home purchase can be exempt from early withdrawal penalties. But this would not be a good strategy for the entire home purchase because the amount you can withdraw is limited to $10,000 for an individual, or $20,000 for a couple. This might sound appealing for those looking to come up with enough money for the down payment on the home purchase, but there are tax implications that could make this a bad move. With traditional IRAs, all withdrawals are subject to income tax.
With Roth IRAs, the 10% early withdrawal penalty applies to the earnings portion of your account, which is different from initial contributions. This means that you would be able to make early withdrawals on your contributions prior to turning 59-1/2 without penalty, assuming you satisfy the Roth IRA five-year rule. This rule states that early withdrawals made from Roth IRA contributions can be done so penalty-free if the Roth account was first opened, and contributions were initially made, at least five years prior to the withdrawal. Satisfying this rule would make this early withdrawal a qualified distribution.
Ideally, you'll have other funds available to you besides your retirement accounts, but sometimes the best laid plans are foiled by fate. Before deciding to raid your retirement account, understand the type of account you have, and the limitations that may be in place for that specific plan. Regardless of the amount withdrawn, 10% can account for a rather large number. The easiest way to avoid this penalty would be to wait until you turn 59-1/2.