Exceptions to the 10 Percent Early Withdrawal Penalty

Recently, we explored the history of the 10% early withdrawal penalty and its implications for IRAs and other employer-sponsored defined contribution plans (such as the TSP). First, we’ll discuss ways to avoid the 10% early withdrawal penalty.

Would you be surprised to learn that IRAs and TSPs have different exceptions? Unfortunately, tax regulations are becoming so murky that I wouldn’t be surprised if the IRS employed a Director of Confusion and Obfuscation. 

Exceptions to the 10 Percent Early Withdrawal Penalty

TSP and IRA’s current list of exceptions are:

1. The account holder’s passing.

2. Difficulty in Moving: If the account holder meets the relatively strict Social Security criteria of disability, they are eligible for this exemption.

3. 72(t) payment plan: Recurring payments are made on the same day each month for a minimum of five years or until the account holder reaches age 59 and a half, whichever comes first.

4. Over 7.5% of the account holder’s AGI was spent on medical care.

• To settle a tax lien.

• Bringing a new child biologically or through adoption into the world.

• Those who are currently serving as active reservists and who meet the requirements.

5. Particular to Individual Retirement Accounts

• Higher education expenses.

• Individual purchasing a home for the first time.

To be able to afford medical coverage in the event of unemployment.

Exceptions that only affect the TSP

1. The account holder must be 55 years old or older and planning to retire in that year or later. If you work in public safety and want to retire in the year you turn 50 or later, this also applies to you.

2. The Disbursement of Funds by a Pursuant to an Appropriate Court Order (e.g., divorce, child support, etc.). 

Exceptions that only affect the IRS

1. The only things guaranteed in life are death and taxes. Congress can’t alter the finality of death, but it may make tax laws. Because of this, the IRS is often called the “attorneys and accountants full employment act.”

2. Expenses for a first-time homebuyer, health insurance premiums due to unemployment, and eligible higher education costs are exceptions that apply only to IRAs.

Please keep in mind that these are broad concepts. To avoid paying the penalty tax, account holders must meet the requirements of one of the several exceptions. The IRS website also has more details on the exemptions.

Questions asked

Is the 10% early distribution penalty tax automatically taken out of the distribution?

On the contrary, the penalty tax will be added to the account holder’s total tax burden when he files his federal income tax return for the year the distribution was made.

What should an account holder do if entitled to a penalty tax exception but no exception code appears in Box 7 of Form 1099-R?

When filing their federal income tax return, the account holder must include a completed copy of Form 5329, Additional Taxes on Qualified Plans (Including IRAs), and Other Tax-Favored Accounts. On Line 2, you’ll see a space to write the applicable exception number and the dollar amount that avoids the tax penalty. In addition, instructions for Form 5329 will include the relevant exemption number.

Do 72(t) distributions from a QRP follow the same guidelines as those from an IRA for the account holder?

Yes, in most cases. However, plan participants are only eligible to receive 72(t) payments once they have retired from service, while IRA owners can do so at any time. QRPs and IRAs are also subject to the same rules, such as taking payments for a set length of time and not being able to make changes to the account once payments have commenced. The IRS’s website has more details about 72(t) payments.

Contact Information:
Email: rick@andrikfinancial.com
Phone: 9568933225

Bio:
Rick Viader is a Federal Retirement Consultant that uses proven strategies to help federal employees achieve their financial goals and make sure they receive all the benefits they worked so hard to achieve.

In helping federal employees, Rick has seen the need to offer retirement plan coaching where Human Resources departments either could not or were not able to assist. For almost 14 years, Rick has specialized in using federal government benefits and retirement systems to maximize retirement incomes.

His goals are to guide federal employees to achieve their financial goals while maximizing their retirement incomes.

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