Main Points
- IRAs are great tools to help save for retirement, but they’re specifically designed for that. The IRS provides tax favorability for these accounts and discourages account owners from making non-retirement withdraws.
- Early IRA distributions have exceptions to early withdraw penalties.
- Other options exist for accessing cash to pay for unexpected events.
(Approximately 5 minute read)
Ideally, your retirement plan (whether it’s a workplace plan such as a 401(k) or a 403(b), or it’s a personal retirement plan like an IRA or ROTH), has a utility for helping you live your life once you quit working. How you live currently can be a reflection of how you continue through retirement, with some added activities like volunteerism, vacation and travel, and even starting a passion project that you’ve been dreaming of. But while you work and build your nest egg, life sometimes has a tendency to mitigate even the strongest savers.
Unplanned life events (illness/injury, unemployment, car repair, roof collapse, etc.) can bring your savings journey to a grinding halt, and many Americans don’t have the prescribed six months’ worth of savings to cover them. So, what can you do?
Types of IRAs Available for Exceptions
Traditional and Rollover IRAs are not the only accounts that qualify for exceptions. Simplified Employee Pensions (SEPs), Savings Incentive Match Plan for Employees (SIMPLEs), and the least common, Salary Reduction Simplified Employee Pensions (SARSEPs), are available to take distributions. SEPs and SIMPLEs are IRAs that are tied to your personal IRA that smaller businesses use to make contributions to your account in lieu of a 401(k). These plans are versatile for employers because contributions can be made on a scheduled basis like payroll deductions or sporadically.
Accessing Your IRA
This isn’t an ideal situation, but let’s say that you’ve suddenly fallen ill and have been unable to work. Maybe your workplace provides a short-term disability plan that comps you a percentage of your salary while you recover, but what about the remainder? Some live paycheck to paycheck, making a scenario like this strenuous, especially when medical bills begin to mount. If you’ve been able to contribute to your IRA in addition to your workplace plan, there are some things you need to know before taking any distributions.
First and most importantly, you need to take from after-tax sources like a savings account or a ROTH IRA. The contributions to these kinds of accounts have already been taxed, so no additional taxes are taken when you make these withdraws (as long as you don’t take any growth from the account). If taxed funds aren’t available, and you have a traditional IRA or a rollover IRA from a previous employer, there are some considerations to account for:
- IRAs are Individual Retirement Arrangements (or Accounts) that are pre-tax retirement vehicles intended for retirement. Distributions from this account are taxed as ordinary income and there’s a 10% tax penalty for taking early distributions, 25% penalty for SIMPLEs taken within 2 years of ownership. This penalty is waived once the account holder turns 59½ under Internal Revenue Code (IRC) Section 72(t)(2)(A)(i).
- Medical expenses qualify for the 10% penalty exclusion, but only if the total of those expenses is more than your Adjusted Gross Income (AGI). Life happens before 59½, but in the case of medical expense buildup, understanding when to take from the IRA for medial purposes is a must.
- Qualifying medical expenses are defined by the IRS under Publication 502¹. Normally, the range of these services and procedures are much broader than what medical insurance would cover. The sum of all qualifying expenses must be tabulated and receipts kept for the following tax filing year to show that IRA withdraws were used to cover medical needs.
- When taking distributions, ordinary income tax will be taken out, so the distributions need to be NET of taxes. Brokerage firms that liquidate assets will automatically withhold federal income tax from these distributions (10 or 20%), but you have the options to tell them how much to withhold, especially if you know your Effective Tax Rate.
Effective Tax=Total TaxTaxable Income
* The Total Tax can be found on your latest tax return on the second page of your 1040. This represents the pre-withholding from W-2s and 1099s in that tax year. Taxable Income is the bottom-line income after deductions and is found on the bottom of the first page of your 1040.
This is only one example where funds can be withdrawn from your IRA, but it’s only one exception of many. Birth or adoption, death, domestic abuse victim, homebuyers, rollovers, are just a few that have their own circumstances that are not subject to the 10% penalty². Please be aware that hardship does not qualify as an exception to the 10% penalty.
Requesting a distribution from your IRA is simple. Either contact a financial professional at your brokerage firm to make the request, or, if you independently manage your account online, you can liquidate this yourself. Be careful to take the right amount out for income taxes or that tax bill will come back to haunt you in the next filing season.
Documents to Expect
Tax forms for the 2024 filing season are due to be sent to taxpayers by January 31. Retirement plan distributions, no matter the reason, will generate Form 1099-R from your brokerage form. This form gives you information on the total distributions, taxable distributions, reason for distribution, federal and state tax withheld, among other things. Box 7 on this form will show the distribution exception for early withdraw.
When taking unqualified, premature distributions from your IRA, you need to file Form 5329 to indicate that a 10% penalty must be applied. But if you’ve taken a distribution for qualified expenses, and Box 7 is blank on Form 1099-R, you will need to file Form 5329 to show the correct exception.
Moving Beyond
Life events don’t have to be a “forever situation,” but it’s nice to be able to plan for the worst. Emergency savings, a privately owned disability insurance policy, privately owned life insurance policies with cash balances and loan provisions, and access to personal loans through your bank are a few examples that help you protect your retirement savings. As I indicated, that’s not always possible, and when you’re confronted with a challenging event, it helps to know your options before you do serious damage to your finances. Reach out to your tax and financial professionals to learn how you can better secure your retirement savings.
Tree City Tax is accepting new clients for the upcoming filing season, including small business returns. You can book a consultation by calling at (330) 539-4231. Small businesses that schedule a consult before the end of the year reduce their likelihood of filing an extension.
- Publication 502: Medical and Dental Expenses; For use in preparing 2024 returns, IRS.gov: https://www.irs.gov/pub/irs-pdf/p502.pdf
- Retirement Topics – Exceptions to tax on early distributions, IRS.gov: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions