4 New Ways to Avoid a Tax Penalty for Withdrawals from Early Individual Retirement Accounts – CNBC

Pension scheme changes to the omnibus expense account

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Retirement accounts are a tax-advantaged way to build your nest egg — but tapping into them too quickly usually results in a penalty.

However, the tax code waives that penalty in some circumstances. And federal lawmakers are about to add a few more, such as when people need money in the event of a terminal illness, domestic violence, natural disaster or some other financial emergency.

The changes are part of a slew of pension reforms – collectively known as “Secure 2.0— that President Joe Biden is about to sign into law as part of a $1.7 trillion federal spending package. Congress passed the legislation last week.

Americans should try to avoid taking money out of retirement accounts early, despite looser rules, financial experts say.

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“The worst thing you can do is withdraw from your retirement account before the intended goal is reached, because then what’s in it for your retirement?” Ed Slott, a certified public accountant and IRA expert based in Rockville Center, New York, previously told CNBC. “I would only do this if it was the last resort and it was all the money you had.”

New exceptions to the 10% tax penalty

Savers in general receive a 10% tax penalty if they withdraw money from a retirement account before the age of 59½. This is in addition to any income taxes arising from the withdrawal.

The following list outlines rules in the new legislative package that waive the 10% early withdrawal penalty for IRA owners. These measures also apply to savers with a workplace retirement plan, such as a 401(k).

1. Terminal illness

A terminally ill person would not be penalized for withdrawing pension funds before age 59½.

The law defines “terminally ill” as any disease or physical condition that can reasonably be expected to result in death within 84 months of a physician’s assessment.

The rule will come into force after the entry into force of the new law.

2. Domestic Violence

Victims of domestic violence by a spouse or partner can withdraw up to $10,000 from retirement funds within a year of the incident. The rule will take effect in 2024.

Individuals may need access to that money to help escape an unsafe situation, for example, the Senate Finance Committee said in a Overview document.

The law defines domestic violence as “physical, psychological, sexual, emotional, or economic abuse, including attempts to control, isolate, humiliate, or intimidate the victim, or to undermine the victim’s ability to reason independently , including through abuse of the victim’s child or other resident relative.”

The victim can withdraw the lesser of $10,000 – an amount that is adjusted upwards based on inflation – or 50% of the account balance.

3. Financial emergency

As of 2024, taxpayers will not be penalized for withdrawing pension funds for certain urgent costs. These are “unforeseen or immediate” costs related to personal or family emergencies.

Savers can make an emergency financial withdrawal of up to $1,000 per year. However, they cannot make additional withdrawals within three years unless they repay the initial benefit or make regular deposits at least equivalent to the amount withdrawn.

4. Natural disasters

Heavy rains caused severe damage and 335 deaths in the Hazard, Kentucky area on August 8, 2022.

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Depositors can withdraw up to $22,000 penalty-free in the event of a federally declared disaster.

The federal government sometimes issues one-time waivers related to certain disasters, but the new law enshrines a permanent rule.

In addition to the fact that the payment is free of penalty, the funds over three years may count as gross income instead of one year. Benefits can also be refunded to the retirement account.

Existing exceptions to the 10% tax penalty

In addition to the new rules, the tax law has several existing exceptions for those under 59½.

(Note: The first three only apply to IRAs. The others can apply to both IRAs and workplace retirement plans.)

1. Expenditure on higher education

You may be exempt from the penalty if IRA funds are used to pay qualifying higher education expenses for you, your spouse, or your or your spouse’s children or grandchildren.

Eligible costs include tuition, school fees, books, supplies, equipment necessary for a student’s enrollment or attendance, and expenses for certain special needs. Board and lodging are also eligible for students who attend school at least half-time.

Students must attend a college, university, vocational school, or other institution that can participate in the U.S. Department of Education’s student aid programs. (They include “virtually all” accredited, public, not-for-profit and private for-profit institutions, according to the IRS.)

2. ‘First time’ home buyer

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Contrary to what the IRS title suggests, IRA owners don’t necessarily have to buy a home for the first time to take advantage of this exception. The IRS generally defines a first-time buyer as someone who hasn’t owned a home in the past two years.

Such IRA owners can withdraw up to $10,000 penalty-free. This dollar threshold is a lifetime maximum.

The money is to be used for “qualified acquisition costs”. These are: the cost of buying, building, or rebuilding a home, and “any customary or reasonable settlement, financing, or other closing costs,” according to the IRS. The funds must be used within 120 days of receipt.

The IRA withdrawal can be used for you, a spouse or your child, in addition to other eligible family members. If both you and your spouse are first-time homebuyers, each can receive benefits up to $10,000 without penalty.

The two-year limitation period starts on the “date of acquisition”: the day on which you conclude a binding purchase contract or on which construction or renovation begins.

3. Health insurance if unemployed

Benefits to cover health insurance premiums for you, a spouse, and dependents may not be penalized if you lose your job.

To qualify, you must have received unemployment benefits (through a federal or state program) for 12 consecutive weeks. The IRA withdrawal must also occur in the year you received unemployment, or in the following year. Furthermore, you must take the withdrawal within 60 days of being rehired.

4. Death

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Beneficiaries who inherit an IRA after the owner’s death are generally not subject to a penalty if they withdraw funds from the inherited account before age 59½.

5. Unreimbursed Medical Expenses

A benefit to cover medical expenses should not be penalized.

The exception applies to non-reimbursed healthcare costs that exceed 7.5% of your adjusted gross annual income. The applicable income is that during the year of withdrawal.

For example, if your AGI is $100,000 in 2022, you can use a withdrawal this year to cover unreimbursed medical expenses in excess of $7,500.

You don’t have to itemize the tax deduction to get this benefit. (In other words, you can still get it if you take the standard deduction.)

Slott warned of a snag at the end of the year. If you put a medical bill on your credit card this week or next week, those medical expenses will count for the 2022 tax year, even if the credit card bill itself isn’t paid until 2023.

That means an IRA withdrawal tied to those medical expenses would have to occur in 2022, not 2023, to get the tax break.

6. Birth or Adoption

Each parent can use up to $5,000 per birth or adoption from their respective retirement accounts. The funds would cover the associated costs.

The account must be withdrawn within one year of the birth of your child or the date on which your child’s legal adoption was completed.

7. Disability

Certain disabled pension savers under age 59½ are not subject to the tax penalty.

To be eligible, they must be “fully and permanently disabled”. The IRS defines this as being unable to do “any substantial gainful activity” because of a physical or mental condition. A physician must certify that the condition is “expected to result in death or be of long, persistent, and indefinite duration.”

All in all, it’s a rigid definition that’s hard to come by, Slott said. In practice, someone generally needs to be near death or bedridden and unable to work, he said.

8. IRS Charge

You won’t be fined if the distribution is the result of an IRS tax levy (ie, if the IRS uses your retirement funds to meet a tax liability).

9. Active Reservists

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Reservists in the Army, Navy, Marine Corps, Air Force, Coast Guard, or Public Health Service may be exempt from a fine.

They must have been ordered or called to active duty after September 11, 2001 and have served for 180 or more days or indefinitely.

Their account distribution cannot take place earlier than the date of the call to active duty and no later than the end of the active duty period.

10. Substantially equal periodic payments

This exemption for IRA owners is “very complicated” and will likely require the help of an accountant or advisor, Slott said.

In basic terms, a taxpayer can avoid a fine by sticking to a formula that outlines a number of periodic bill distributions (at least one per year). These “substantially equal periodic payments” are like an annuity and are also known as 72

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