Exceptions to the 10% Penalty for Both IRAs and Company Plans | Ed Slott and Company, LLC

Exceptions to the 10% Penalty for Both IRAs and Company Plans

By Sarah Brenner, JD
IRA Analyst
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Retirement accounts are supposed to be for saving for retirement. If you tap your retirement savings before reaching age 59 ½, you run the risk of being hit with the 10% early distribution penalty. However, there are exceptions to this penalty. Some apply just to IRAs and some apply just to employer plans. However, the following six exceptions apply to BOTH distributions from IRAs and employer plans.


1. Death

A distribution taken from an inherited retirement account after the death of the owner is never subject to the 10% penalty. It does not matter what the age of the owner was or what the age of the beneficiary is.

2. Disability

If a distribution is taken from a retirement account, the 10% penalty will not apply if you are disabled. The standard for disability for this purpose is a strict one and it is difficult to meet. You must be unable to engage in any gainful activity because of a physical or mental condition. The condition must be expected to last a long and indefinite period of time or be expected to result in death. In other words, the disability must be total and permanent. The disability must be present at the time the distribution is taken. You should proceed with caution because the standard for proving disability is so high. Consider using other non-retirement assets to fund needs first. Also, be sure that you have documentation from medical professionals to back up the claim of disability.

3. 72(t) Payments

You may set up a series of payments from a retirement account and avoid the early distribution penalty. These payments are sometimes called 72(t) or substantially equal periodic payments. These payments are only available from an employer plan after separation from service. To qualify, the payments must be calculated in a very specific way and must be taken at least annually. If there is a modification of the payments before the client reaches age 59 ½ or before five year have passed, the client will be hit with the 10% penalty (plus interest) on all distributions already taken prior to age 59 ½ under the payment plan. Possible modifications include taking an extra distribution or not taking enough. Any change to the balance, other than gains or losses, may be a modification as well. Because the rules are strict and the penalties are severe, you will want to be sure that you are committed to this method of payments and willing to comply with all rules for what may be a long period of time.

4. Reservist Distributions

If you serve in the military reserves, there is an exception to the early distribution penalty that may be helpful. A reservist who is called to active duty for more than 179 days or for an indefinite period of time may take penalty-free distributions from their retirement account.  The distribution must be made no earlier than the date the reservist was called to active duty and no later than the end of the active duty period.

5. Deductible Medical Expenses

Distributions are not subject to the 10% penalty if the distribution does not exceed your deductible medical expenses for the year. This is the case even if you don’t itemize deductions. The distribution must occur during the same year in which you pay the expense. Generally, medical expenses must exceed 10% of your adjusted gross income. Good record keeping is a must.

6. Tax Levies

Funds paid due to a tax levy by the IRS are not subject to the early distribution penalty. This only applies when the retirement account is actually levied by the IRS. The exception would not apply if you take an early distribution to pay taxes owed but there is no levy.

 


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