Hugh F. Wynn
IRA Withdrawal Exceptions: More Rules For The Tools
The main concern folks – especially young folks – have with IRAs is their “forever” feature. “I make contributions to the darn thing, and it’ll be FOREVER before I have access to those dollars,” they grumble.
Generally speaking, an early withdrawal from an IRA prior to age 59½ is a big no-no, subject to being included in gross income plus a 10% additional tax penalty. There are exceptions but avoid them if you can.
The main concern folks – especially young folks – have with IRAs is their “forever” feature. “I make contributions to the darn thing, and it’ll be FOREVER before I have access to those dollars,” they grumble. Well, sort of true. IRA rules are designed to discourage you from dipping into the till prematurely as opposed to waiting until the greybeard years (post-59½) for access. After all, IRAs are instruments of retirement. But to assuage some of the apprehension related to this “forever” feature are a few exceptions to the 10% additional tax penalty on early withdrawals.
As youngsters mature and adults grow older, they will come to appreciate the benefits, and on occasion, the early withdrawal exceptions of an IRA – the ability to tap the account for certain very specific purposes. Let’s discuss a few, keeping in mind that the exceptions I mention also have some very specific provisos that must be met to avoid triggering that darn early withdrawal tax penalty. Let’s consider a few exceptions:
In the event of job loss, you can make early withdrawals to pay for healthcare insurance premiums.
You can pay for medical expenses that exceed 10% of your adjusted gross income.
If disabled, to qualify as a tax penalty exception, you must obtain a doctor's verification as proof of your inability to do productive physical or mental activity indefinitely.
You can pay qualified higher education expenses for yourself, a spouse, and for offspring, but only if paid to eligible educational institutions.
You can early withdraw to buy, build, or rebuild a first home for a parent or grandparent, yourself, a spouse and for offspring, but you must meet the IRS definition of a first-time home buyer. If both you and your spouse qualify as first-time home buyers, then each of you can withdraw $10,000 from each of your respective IRAs without penalty.
A qualified reservist distribution is not subject to the penalty tax if certain requirements are met, including a call to active duty for more than 179 days or for an indefinite period as a member of a reserve component.
The Substantially Equal Periodic Payment (SEPP) rule allows holders to withdraw retirement account money at any age, penalty-free. There are 3 IRS-approved methods for calculating SEPP withdrawals and you must adhere to such schedules for at least 5 years, or until age 59½ (whichever occurs later), or all amounts withdrawn may become subject to the 10% penalty tax.
We’ll discuss inherited IRA withdrawals at another time.
I purposely mention these exceptions because so many folks avoid using IRAs using the excuse that they tie up money “forever” that might be needed to meet more pressing current needs. In doing so, these same people overlook an IRA’s tax-advantaged value of saving money for retirement, long-term exposure to an up trending market, and the benefit of The Amazing Power of Compounding.
Before dismissing IRAs out of hand, remember that there are ways to access IRA accounts for specific purposes, but fair warning, the rules covering Traditional and Roth withdrawals are not all the same. Do your homework and think twice before making a withdrawal.
Ah, More Examples
Let’s review some examples of what The Amazing Power of Compounding can do for savers who follow different contribution patterns. A single $2,000 IRA contribution made at age 15 could grow to almost $59,000 after 50 years, assuming a 7% investment yield, compounded annually. If that same saver contributed the initial $2,000 but added an additional $50 each month for 50 years, the account would grow to about $312,000, earning the same 7% per annum. And if the saver doubled the contribution to $100 each month, the account could reach over $565,000 after 50 years. As youngsters “earn” more money after entering the adult workforce, their annual contributions are likely to be higher, and the resultant IRA balance will grow correspondingly. Amazing, huh?
What’s The Point?
Aside from pointing out the withdrawal flexibility of IRAs, another purpose of today’s discussion is that since America has devolved into a “do-it-yourself” retirement system (Defined Contribution Plans) as opposed to the old pension system (Defined Benefit Plans)¹, the so-called “wealth gap” between wise early savers and those who choose to wait has morphed into a “wealth chasm”. Contributing to the chasm is the choice of wise savers to avoid the 10% early IRA withdrawal penalty, a penalty our legislators included when passing laws establishing IRAs and other retirement accounts. The withdrawal message is simple: Follow the rules and reap major rewards – violate them and suffer the consequences.
In summary, teaching our younger generations the value of opening Traditional or Roth IRAs – and yeah, Gramps, occasionally providing matching contributions – helps provide them with a head start on saving for retirement. You can also teach them useful lessons about taxes, smart investing, The Amazing Power Of Compounding, and the very important relationship between earning, saving and spending. Discipline, discipline, discipline is the watchword – so important in developing healthy financial habits.
Finally, don’t be intimidated by the “forever” nature of IRAs. There are ways to access funds in both Traditional and Roth IRAs prior to retirement. Still, IRAs should be funds of last resort to raid, but if the pitcher of life throws you an occasional wicked curve, we