General Penalty Waivers
There are expenses and circumstances that can waive the 10% early withdrawal penalty on a distribution regardless of what plan type the taxpayer has:
- Plan asset rollovers (not conversions)
- Qualified higher education expenses
- Being age 59 ½ at the time of distribution
- Deductible medical expenses that exceed 10% of adjusted gross income (7.5% if taxpayer or spouse is age 65 or older) regardless of whether taxpayer itemizes
- Becoming permanently and totally disabled
- Distributions made on account of an IRS levy
Waivers Only if Taxpayer Has a Qualified Plan
Since qualified plans are dependent upon a relationship with an employer, assumed to be a long-term one, a penalty exception that exists only for this plan type is if the taxpayer separated from service in or after the year they turn 55.
Loans taken against a 401(k) are beyond this article’s scope but worth mentioning since 401(k) loans paid back in full with interest are not considered taxable income or subject to the penalty; while IRAs and non-qualified plans cannot be borrowed against.
Waivers Only if Taxpayer Has an IRA
Traditional IRAs place the risk burden solely on the taxpayer, not any employer(s) thus they present more opportunities to have impunity from the early withdrawal penalty with proper planning.
If a taxpayer becomes unemployed, receives unemployment comp for at least 12 weeks, and is paying for medical insurance for themselves and spouse/dependents, IRA distributions used for this purpose are generally penalty-free.
First-time homebuyers can also use IRA distributions to purchase or build a new home.
Ergo, it is strongly suggested that if your clients fall into one of the above situations and have a qualified plan, they should roll funds into an IRA to avoid being penalized if they must draw on that plan.
Since Roth IRA contributions are not pre-tax like IRAs and 401(k)s, taxpayers have a little more flexibility with early withdrawals in that the penalty only applies to asset growth relative to the distribution, not the contribution itself. The same penalty exceptions apply as they would for traditional IRAs.