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New exceptions to 10 percent
penalty on early IRA withdrawals

In general, taxpayers younger than age 591/2 must pay a 10 percent penalty if they withdraw money from their IRA. As this tax tip explains, exceptions to this rule apply for hardship cases involving death or disability. Withdrawals established as an IRS-approved annuity are also exempt.

Tax legislation in 1997 and 1998 implemented additional exceptions to the 10 percent premature IRA withdrawal penalty. This tax tip explains the circumstances required for withdrawals covering expenses for medical, insurance, educational, and first-time home purchases to be exempt from this penalty. A basic requirement for avoiding the penalty in all of these cases is that the qualified expense exceeds the IRA distribution.

Generally subject to penalty
The general rule for traditional IRA distributions hasn't changed. If you are at least age 591/2 when you withdraw from your IRA, you pay income tax only on the distribution. If you withdraw from your IRA before you reach age 591/2, you must pay a 10 percent penalty tax, in addition to your regular income tax, on this distribution. There are a few exceptions to this penalty:

  • Distributions from IRA of deceased taxpayer under age 591/2 at death.
  • Distributions to disabled IRA participant under age 591/2.
  • Distributions made as part of a series of substantially equal payments over the life of a participant, or the joint lives of participant and beneficiary.
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There are two requirements associated with the third exception. You must use an IRS-approved distribution method and take at least one distribution annually. Refer to IRS Publication 590, Individual Retirement Arrangements, for additional information.

These original exceptions remain pertinent under the new legislation. Remember that distributions meeting these exceptions are still subject to regular income tax; they merely escape the 10 percent penalty.

Penalty-free distributions
Tax year 1997 introduced two additional exceptions to assist taxpayers in hardship situations involving:

  • Significant unreimbursed medical expenses
  • Paying medical insurance premiums after losing your job

Medical expenses: Pre-age 591/2 distributions less than the amount of deductible medical expenses aren't subject to the 10 percent penalty. This applies even if you don't itemize deductions. As long as the expenses you could deduct equal or exceed the distribution, you meet the exception.

Don't casually withdraw IRA funds to pay for all of your medical expenses and assume you will avoid the penalty! Make sure you understand the IRS limitation on medical expenses. The IRS only considers medical expenses that exceed 7.5 percent of your adjusted gross income (AGI) for this deduction. Once you've determined that these expenses qualify for this deduction, you must make sure that they are less than your IRA withdrawal to avoid the penalty. The table and example that follow clarify the consequences of combining this exception with this limit.

A taxpayer incurs $15,000 in medical expenses in 1998. His adjusted gross income (AGI) for 1998 is $100,000. He pays these bills by withdrawing $10,000 from his IRA. He will pay a penalty of $250, computed as follows:

  Formula Calculation
in Example
Answer
Deductible medical expenses 7.5% x AGI 7.5% x $100,000 $7,500
IRA distribution in excess of deductible medical expenses IRA distribution - Deductible medical expenses $10,000 - $7,500 $2,500
Penalty due on excess medical expenses Excess of deductible medical expenses x 10% $2,500 x 10% $250

Step 1: Review of the taxpayer's 1998 situation:
Total medical expenses: $15,000
AGI: $100,000
IRA distribution: $10,000

Step 2: Determine this taxpayer's deductible medical expenses as based on the AGI limitation.
Deductible Medical Expenses = AGI Limitation
AGI x 7.5%=$100,000 x 7.5% = $7,500

Step 3: Calculate this taxpayer's distribution in excess of deductible medical expenses
Distribution in Excess of Deductible Medical expenses = Total medical expenses - AGI Limitation
$10,000 - $7,500 = $2,500

Step 4: Determine the taxpayer's penalty due for distribution in excess of deductible expenses.
Penalty = Excess of deductible medical expenses x 10%
$2,500 x 10% = $250

Another exception implemented in 1997 assists unemployed individuals. If you are younger than age 591/2, and your IRA withdrawal is less than your medical insurance bill, you are exempt from the 10 percent penalty if:

  • You have received unemployment compensation for at least 12 consecutive weeks, and
  • The withdrawal is made in the year this compensation is received, or in the following year.

This exception applies to the entire amount paid for insurance. It doesn't just apply to the amount deductible after the 7.5% AGI limit is met.

Higher education and home purchase exceptions
1998 introduced two additional exceptions for expenses incurred for higher education and first-time home purchases.

Higher Education: An IRA withdrawal before age 591/2 used to pay qualified higher education expenses listed in the table below is no longer subject to the 10 percent penalty. As with the other exceptions, the basic requirement is that the qualified expenses equal or exceed the withdrawal.

Qualified higher
education expenses

Conditional on:
Tuition and fees
Expenses are required by an eligible educational institution
Books and supplies
Equipment
Room and board
Expenses are required by an eligible educational institution and the student attends at least half-time

The expenses must be incurred by one of the following: you, your spouse, your spouse's children, your grandchildren or your spouse's grandchildren.

First Time Home Purchases: The other new exception effective for 1998 applies to homebuyers. A maximum of $10,000 of distributions for first-time homebuyer expenses is eligible for the exception. The 10 percent penalty tax doesn't apply to pre-age 591/2 IRA distributions to pay for "first-time" homebuyer expenses.

For this exception, a "first-time" homebuyer isn't necessarily someone buying a home for the first time. Rather, you are a "first-time" homebuyer if you haven't owned a home for two years.

The withdrawal must be used within 120 days of distribution to pay reasonable settlement, financing or other closing costs for a principal residence. The homebuyer can be you, your spouse, or any child, grandchild, etc. of you or your spouse. This greatly enhances the availability of the exception: a husband and wife wishing to assist their children in purchasing a home can each withdraw up to $10,000 over their lifetime without penalty.

Conclusion
In general, taxpayers must pay a 10 percent penalty on any IRA withdrawals they make before the age of 591/2. This tax tip explains some general exceptions to this rule for hardship cases involving death or disability, as well as withdrawals established as an IRS-approved annuity. Tax legislation in 1997 and 1998 implemented additional exceptions to the 10 percent premature IRA withdrawal penalty. This tax tip describes the circumstances required for withdrawals covering expenses for medical, insurance, educational and first-time home purchases to be exempt from this penalty. A basic requirement for avoiding the penalty in all of these cases is that the qualified expense exceeds the IRA distribution. While the distributions described here are still subject to regular income tax, their exclusion from the 10 percent penalty tax will help taxpayers finance these potentially burdensome costs.

--Nov. 1, 1999

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