IRS is eyeing early distributions from IRAs…And qualified employer plans such as 401(K)s. The agency wants to make sure that individuals are properly reporting payouts taken before the age 59 ½. The issue is a common IRS Audit red flag. A 2015 review found that 40% of people scrutinized made mistakes, with most coming from taxpayers who didn’t qualify for one of the numerous exceptions to the 10% additional excise tax on early distributions.
The 10% fine hits most pre-age-59 ½ payouts. It’s in addition to the regular income tax that is due. But there are important exceptions. Some apply to both IRAs and 401(k)s. Others, to one or the other. We’ll review some to the common exceptions here.
Early withdrawals from IRAs to help “first-time” home buyers are penalty-free. IRA owners can take out up to $10,000 to help buy or build their primary home or one for a spouse, child, grandkid, parent or grandparent. The funds must be spent within 120 days. You can be a first-time homeowner even if you owned a home before, as long as you and your spouse didn’t own a home in the previous two years.
Ditto for the cost of higher education…college tuition, books, computers, supplies, and room and board for students enrolled at least half-time. Unlike for home buyers, there’s no dollar cap. To qualify for the exception, payouts must cover education costs for the IRA owner, spouse, child or grandkid that are paid in the year of the withdrawal. Early distributions form 401(k)s for education or first home don’t get relief.
Taking substantially equal payments from an IRA or 401(k) is a key exception. Distributions must continue for the longer of five years or until the recipient hits 59 ½. Withdrawals must be based on the owner’s life expectancy or the joint life expectancy of the owner and named beneficiary. If the payouts vary too much from year to year, all previous distributions taken from the account will be hit with the 10% tax.
IRAs and 401(k)s can be utilized to pay big medical expenses without penalty. The funds must be used for medical costs of the taxpayer, spouse or dependent. The payout must cover expenses paid in the year of the withdrawal. Only medicals that exceed 10% of adjusted gross income (7.5% for 2018) qualify for the exception. The unemployed can use IRA funds to buy health insurance in some cases. Payees must be on unemployment for 12 weeks. Self-employed individuals also qualify. There other exceptions to the penalty do not allow much planning: Death or permanent disability of the account owner or IRS levy on retirement funds.
IRS has a helpful chart listing all withdrawals that escape the 10% penalty. It describes the exceptions, notes those that apply to 401(k)s and those that apply to IRAs, and lists the section of the income tax code where the exception appears. Go to www.kiplinger.com/letterlinks/earlydsitributions to view the complete list. Note there is no general hardship exception to the 10% tax on early payouts.
The Kiplinger Tax Letter
Volume 94, No. 17