Take-Away: We are all familiar with the 10% penalty that is assessed when funds are withdrawn from an IRA or qualified retirement plan account when the IRA owner or plan participant is under the age 59 ½ years.  The good news is that there are some exceptions to the imposition of this 10% penalty. The bad news is that the exceptions vary with the circumstances warranting the withdrawal, or they vary with the type of retirement plan from which the withdrawal is taken. Consequently,  it is easy to make the wrong assumptions with regard to when an exception applies and what conditions apply to which type of retirement plan from which the withdrawal is taken. In addition, there may be situations where more than one exception applies to the same distribution, but the permissible amounts may differ for each exception.

Background: There are a limited number of exceptions to the 10% penalty [which is actually an excise tax] that is imposed when retirement funds are taken prior to the IRA owner or plan participant attaining the age 59 ½. The 10% penalty is imposed if funds are taken prior to the owner/participant actually  being age 59 ½, so be careful that the owner/participant is actually that age if the goal is to meet one of the exceptions- ‘ it was withdrawn in the year I reached age 59 ½’ is insufficient. What is important to keep in mind is that some exceptions only apply to qualified plans, others to IRAs, and some to  distributions from either an IRA or a qualified plan, but the dollar amount could be limited. Do not make the mistake of assuming that an exception that applies to an IRA distribution also applies to a distribution from a qualified plan. Commingling the exceptions can only lead to trouble.

Exceptions: Some of the key exceptions to the 10% penalty  or some misconceptions about when an exception is available are summarized below:

Financial Hardship Distributions: There is NO exception from the 10% penalty for distributions from either a qualified plan or an IRA for the owner/participant’s financial hardship. This is a common mistake many have stumbled over. A plan may permit a hardship distribution, but that does not free the participant from the 10% penalty if the distribution is taken while under the age 59 ½.

Roth Conversions: The  conversion of a regular IRA to a Roth IRA, or an in-plan conversion of plan assets to a plan ‘Roth account’ is not subject to the 10% penalty. But if IRA funds are withheld and used to pay the income tax due on that conversion will be subject to the 10% penalty. Also, Roth funds that are withdrawn to pay the income tax on the conversion will also be subject to the 10% penalty if the owner is under age 59 ½.

Distributions on Death: No surprise here, if your dead but did not make it to age 59 ½, there is no 10% penalty for distributions from either your IRA or your qualified plan account.

Distributions from an Inherited IRAs: There is no 10% penalty imposed on a beneficiary- heir who takes required minimum distributions from an inherited IRA.

457 Plans: A 457 plan is a retirement plan that is sponsored by a governmental employer. There is no 10% penalty imposed on a distribution from a 457 plan if the 457 participant is under the age 59 ½.

Surviving Spouse Distributions: If a surviving spouse is the named beneficiary of the decedent’s IRA and the survivor rolls the decedent’s IRA into their own IRA account, the 10% penalty will be imposed on the survivor if he or she is under the age 59 ½ and starts to take distributions from that rollover IRA. If the surviving spouse does not roll the IRA balance into their own IRA, but the survivor takes distributions from the deceased spouse’s IRA or qualified plan account, i.e. treats it as an inherited IRA, there will be no 10% penalty imposed on distributions to the survivor regardless of the survivor’s age- but the survivor will have to take required minimum distributions which might not be the case with a rollover of the amount to a spousal rollover IRA, where required minimum distributions can be delayed until the survivor attains age 70 ½.

Distributions on Disability: This exception applies to both an IRA and to a qualified plan account. There is no 10% penalty if the owner/participant is disabled. However,  disability is narrowly defined at IRC 72(m)(7) to only cover disabilities where the individual is unable to engage in any substantial gainful activity by reason of the disability…which can expected to result in death or to be of long term or indefinite duration. The trap is that many assume that if the owner/participant is collecting disability payments under an insurance contract or from the Social Security Administration that they automatically qualify for this exception, but that is not the case.

Distributions Incident to Divorce: If the participant in a qualified plan becomes divorced, and their retirement account is divided pursuant to a Qualified Domestic Relations Order [QDRO] then no 10% penalty is imposed on either the participant or his/her former spouse for distributions from the qualified plan. However, this exception does NOT apply to IRAs that are divided in a divorce decree pursuant to IRC 408(d). The trap is when the former spouse rolls the assigned portion of the qualified plan account into his/her own IRA, which is often the case, and then proceeds to take distributions from that rollover IRA. If the former spouse is under the age of 59 ½ years, then the 10% penalty will be applied for distributions taken from his/her rollover IRA.

Age 50 Distributions: Public safety employees [e.g. police, fire, EMS, air traffic controllers] employed by a state or federal employer may take distributions from an employer plan without the 10% penalty if (i) they separate from employment; and (ii) are over the age 50 years of age. If the employee separates from service prior to age 50 years, but delays taking the distribution until after attaining age 50 years, that  will not work to fit within this exception. This exception applies only to employer sponsored plans and not to IRAs.

Qualified Reservists: This exception applies to both IRA owners and qualified plan participants. If that person is called up to active duty for more than 179 days, any distributions taken by the reservist will not be subject to the 10% penalty. Note, further, that the reservist can re-contribute the withdrawn amount back into their account or their IRA within two years of when their active duty ends. However, because the re-contribution is not tax deductible, it makes more sense for the reservist to contribute that amount to a Roth IRA.

Age 55 Distributions: An exception to the 10% penalty applies to distributions made from an employer plan when the participant separates from service in the year that they attain age 55 years or later. As with the above exception for public safety employees,  if the employee separates from service prior to attaining age 55 years, but delays taking the distribution until after attaining that age, the participant will not fit within the exception. Additionally, this exception does not apply to any IRA that is owned by the participant, regardless of their age.

Substantially Equal Periodic Payments: This exception applies to both an IRA and a qualified plan account. It applies at any time with the IRA, but only after the participant separates from service from the qualified plan sponsor. The distributions must be (i) substantially equal in amount; (ii) taken over a period of 5 years or until age 59 ½, whichever is later. The amount is determined following an formula provided by the IRS, and must use an interest rate that is not more than 120% of the federal mid-term rate of interest when the distributions begin. If a mistake is made during the distribution period, all distributions will be subject to the 10% penalty. Note, too, that the account balances used to make the periodic payment calculation cannot be changed by making additions to the account, or by taking additional distributions once the amount is determined. In short, no ‘games’ should be played if this exceptions is used, just take the periodic installment payments for at least 5 years, to avoid the retroactive application of the 10% penalty. See Rev. Ruling 2002-62 and IRC 72(t) for details on how to calculate the periodic payment amount and the interest rate used in the calculation.

First Time Home Buyers Distribution: This exception applies only to distributions from IRAs, not from qualified plan accounts. This is a pretty broad exception, since the buyer could be purchasing their second, third, fourth, etc. home. The only requirement is that they have not owned a principal residence for two years prior to the purchase of the new home.[Note, if married, both spouses have to meet the two year minimum in order to qualify for the exception.] This exception includes funds used to purchase homes for children, grandchildren, or ancestors of the owner or his/her spouse. But the exception is limited to $10,000 per person during their  lifetime. The withdrawn funds must be used within 120 days of the actual home purchase. If the closing on the purchase of the home is delayed, the funds can be re-deposited into the owner’s IRA, and that re-deposit will not subject to the customary 60 day rollover limitation with other distributions from an IRA.

Health Insurance Expenses: This is yet another exception that only applies to distributions from IRAs. This exception from the 10% penalty is limited to the amount paid for health insurance for the owner, his/her spouse, and dependents. In order to qualify the distribution must be in the year that the owner became unemployed or in the following calendar year, and the owner must also be receiving state or federal unemployment compensation for 12 consecutive weeks in the year of unemployment or the following calendar year. The exception does not apply, however, if the owner has been reemployed for 60 or more days.

Medical Expenses: This exception applies to both qualified plan distributions and distributions from IRAs. The exception applies to medical expenses for the owner/participant, their spouse, or a dependent. The distribution must be taken in the year that the expense was incurred. What constitutes a medical expense follows the definition of a medical expense that can be deducted on a 1040 tax return, but there is no obligation to actually itemize all medical expense deductions in order to qualify for this exception.

Higher Education Expenses: This is one more exception that only applies to distributions form IRAs. The distribution must occur in the year the education expenses were actually incurred for post-secondary education, not in the year the expenses are paid. This exception covers books, tuition, housing, fees and computer equipment. Unlike the first time home buyer exception, there is no dollar limit for the higher education expense exception.

IRS Levy: The IRS can levy both a qualified plan account or an IRA to access funds to seize funds to pay off debts owed to the IRS. There is no 10% penalty imposed if the IRS forces a distribution via its levy power. Note, however, that if the taxpayer takes a distribution from either their IRA or their qualified plan account in order to pay the IRS, there will be a 10% penalty imposed if that individual is under age 59 ½. Consequently, it makes more sense to just let the IRS take the funds pursuant to its levy power.

Two final points:

  • Reporting the Exception: Some of these exceptions will reported to the owner/participant on a Form 1099-R issued in the year following the distribution; simply filing the Form 1099-R with the 1040 tax return will be sufficient for the IRS. But other exceptions, e.g. first time home buyer, will not be known to the plan sponsor or IRA custodian. In those situations where the exception is not readily apparent and thus does not appear flagged on the Form 1099-R, the owner/participant will have to file a separate Form 5329 to provide additional information to the IRS to identify the exception claimed [where a number will be assigned to the specific exception claimed by the taxpayer.]
  • Documenting the Exception: It is the responsibility of the IRA owner or the plan participant to prove that they have met all the requirement in order to qualify for an exception to the 10% penalty. It is not the responsibility of a plan sponsor or IRA custodian to confirm that an owner/participant meets an exception or that they possess all of the information necessary to document the claimed exception.