Are There Potential Tax Pitfalls in Early Retirement Distributions?

Early Distribution Penalties

In most cases, those who wish to take an early retirement distribution will be hit with a 10% penalty or more, according to the Internal Revenue Service. The reason for this penalty is to encourage those who are participating in these resources to engage in long-term plans rather than to enter it at a young age and remove what you may have built.

Does this mean that each withdrawal is subject to a penalty? Not necessarily. If the reason for withdrawal falls within some of the categories listed below, you may avoid penalties and utilize the money as you see fit.

Read on to learn more.

Medical Expenses; An Exception to an Early Retirement Distribution

In most cases, money needed for medical expenses may be ineligible for the 10% penalty. Amounts withdrawn and used for legitimate medical expenses in the same year the funds were distributed may not be subject to the penalty.

How do you know if you qualify? If your medical expenses are more than 7.5% of your adjusted gross income for the year in which they were incurred, you may be eligible for early distribution without penalty. Furthermore, medical expenses may be considered suitable for more than just you, including your spouse or dependents as well.

Examples of medical expenses can include health insurance premiums, dental costs, prescriptions, and more.

Higher Education Expenses

What if you need money for college or other higher education opportunities? You may be eligible to use some of the funds as an early distribution and avoid the 10% penalty for doing so.

It’s important to note that the funds needed can generally be used for your needs and higher education for your spouse, your children, grandchildren, and more.

Some items that funds may be used for include books for school, tuition, computers or other equipment needed, and other supplies. Consult your experienced attorney for guidance before the withdrawal to ensure that you may avoid the penalty and that it’s the most financially sound choice for you and your family.

First-Time Home Buyer

Another available exception to the 10% penalty is for first-time home buyers. This exemption won’t apply to all, but if you want to withdraw up to $10,000 from your retirement funds to use to purchase a home, you may be able to do so without penalty.

It’s important to note that even if you have purchased a home before, as long as it has been at least two years since you owned a home, you may still qualify for a withdrawal without penalty. Those who purchased a home years ago and then chose to rent for a couple of years if they moved to another state, for example, and are now looking to purchase a home, may qualify for the exemption.

However, the lifetime cap on the amount you can withdraw without penalty is $10,000. This amount is essential to understand because it may not be enough for a down payment, but it could subsidize funds you have set aside to allow for a more significant down payment on your home, making your dream home more attainable.

Substantially Equal Periodic Payment

Another option that makes funds exempt from the 10% penalty is a SEPP or Substantially Equal Periodic Payment. Annual distributions are made to the recipient, penalty-free, for five years or until the recipient reaches the eligible age of 59.5.

The IRS sets formulas to determine what amounts are eligible and how they will be distributed. Formulas such as the Fixed Amortization Method, the Required Minimum Distribution Method (RMD), or the Fixed Annuitization Method may apply, and you should thoroughly examine each method to determine what options are best for you should you choose to apply for a SEPP.

SEPP plans especially appeal to those who wish to bridge the gap between when they receive their last paychecks and when they will begin receiving other retirement income. A disadvantage to SEPP plans is that the payments are relatively inflexible, meaning that once they start, altering them in any way can be challenging. This disadvantage may mean they are not as helpful as they once were, depending on when the individual began the process.

Other Exemptions

Some other exemptions may apply, such as the exemption for birth or adoption withdrawals. Typically, individuals can expect to withdraw up to $5,000 for each event without being subjected to the 10% penalty.

Those receiving unemployment benefits for twelve consecutive weeks or more may be eligible for penalty-free withdrawals for health insurance premiums.

Those who are deemed disabled may be able to avoid the early withdrawal penalty as well. There are rather strict guidelines for determining who is disabled, but by working with your medical staff and your legal professional, you may be eligible for penalty-free withdrawals.

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With decades of experience, our team is known to our clients as treating them as if they were family. We respect our clients’ complexities and treat them with compassion and determination to help ensure the best results for each situation rather than offering a “cookie-cutter” approach.

Contact our office today at (248) 997-4394 to learn more about how we can best assist you with your needs. We offer reasonable fees and a customized approach to navigating this chapter of your life and getting you on to the next with confidence and peace of mind.