One of the reasons I recommend that you have sufficient money on reserve for emergencies is that it helps you avoid the temptation to take an early withdrawal from your traditional IRA when one of the unexpected events of life hit you. In most cases, if you are under age 59 1/2, you must pay ordinary federal and state income tax, plus a 10% additional tax, on any distribution from your traditional IRA. If you have to file a California tax return for any reason (sometimes even as a non-resident), you will probably have to pay that state a 2 ½ % additional tax on top of everything else. I have seen way too many cases where people have 20% of their distribution withheld for tax, thinking that is a lot, but at least their tax is covered. Then when the actual tax works out to be 40% or even 50% of their IRA distribution, they owe thousands more when they file their tax return, which they don’t have.

I urge you to find other ways to pay for life’s unexpected events besides taking money out of your IRA early!

If an early IRA distribution is absolutely unavoidable, there are a few exceptions that may at least avoid the penalty of the 10% additional tax. These exceptions may include:

Continuing Medical Insurance When Unemployed. An early IRA distribution that is less than your out-of-pocket cost of medical insurance is exempt from the 10% additional tax if you lost your job, received unemployment compensation for 12 consecutive weeks, and receives the early distribution no more than 60 days after you have been reemployed... If you can claim the self-employed medical insurance deduction or the itemized medical deduction, you can effectively avoid all tax on this portion of an early IRA distribution.

High Unreimbursed Medical Expenses. You are also allowed the same exemption on an early distribution that is less than the amount by which your unreimbursed medical expenses exceeds 7.5% of your adjusted gross income. You do not have to be unemployed or itemize your deductions to be exempt from the 10% additional tax in this situation.

Disability. If your physician certifies in writing that you have a disability which can be expected to result in death, or to be of long, continues, and indefinite duration, you are exempt from the 10% additional tax on any early IRA distributions.

Higher Education Expenses. Early IRA distributions that are less than the amount of IRS qualified higher education expenses paid for you, your spouse, or a child or grandchild of you or your spouse are exempt from the 10% additional tax. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required at any college, university, vocational school, or other postsecondary educational institution eligible to participate in U. S. Department of Education student aid programs. These expenses are only qualified to the extent that you paid them, and were not reimbursed by a scholarship, fellowship, employer, veterans’ educational assistance, grant, or tax-free distributions from a Coverdell education savings account or education IRA.

Buying, Building, or Rebuilding a First Home. Early IRA distributions up to $10,000 that are used within 120 days to pay qualified home acquisition costs for the main home of a qualified first-time homebuyer are also exempt from the 10% additional tax. Qualified home acquisition costs include the costs of buying, building, or rebuilding a home as well as any usual or reasonable settlement, financing, or other closing costs to acquire the home. A qualified first-time homebuyer could be you or your spouse, or the child, grandchild, or parent of you or your spouse if that person (and his or her spouse) had no interest in a main home for at least two years prior to the acquisition date of the new home.

Receiving IRA Distributions In The Form Of An Annuity. You can choose to receive IRA distributions in equal monthly installments over your life expectancy or the joint life expectancies of you and your beneficiary without paying the 10% additional tax, regardless of your age. The life expectancies for purpose of these equal monthly IRA distributions must be computed according to rules established by the IRS, which you will want to review before starting such a program. However, if you decide to retire before age 59 ½, this exception can be a real benefit!

Receiving IRA Distributions as a Beneficiary of Someone Who Dies. If you receive IRA distributions as a beneficiary of someone who dies, you do not have to pay the 10% additional tax regardless of your age or the age of the person who died. However, if you inherit an IRA from a spouse who dies, and you elect to treat it as your own (to postpone paying the regular tax on the money), if you later take a distribution before reaching age 59 ½ you will be subject to the 10% additional tax unless you then qualify for one of the other exceptions that have been described here.

Care should also be taken with IRA accounts at the time of divorce. There are exceptions to the 10% additional tax on some distributions from employer retirement plans resulting from a divorce decree, but no exceptions for divorce related IRA distributions. If you are receiving control of part of a former spouse’s IRA account in a divorce, you should either make a direct transfer of those IRA assets to your IRA account, or arrange to have the name changed on the IRA to your name. If you receive the money, you will be liable for full regular taxes plus the 10% additional tax.

Also note that while taking an IRA distribution to purchase a first home can meet an exception to the 10% additional tax, taking one to make mortgage payments to keep a home even if you are unemployed or temporarily disabled will subject you to full regular tax plus the 10% additional tax. This is one reason it is so important to keep an emergency fund handy for just such a situation. Most people have at least one (if not more than one) period of three months or more with no income during their lifetime. If you have to resort to using IRA funds before age 59 ½ during such a period, it can be absolutely devastating to your finances. The usual result is that you have an unexpected tax bill when you file your return several months after the IRA distribution, which you have no way to pay except to take another IRA distribution. This of course results in more taxes and penalties, which I have seen more than once continue in a spiral until the IRA is completely depleted, often leaving the person with no other retirement funds. Please prepare so this doesn’t happen to you!

Important Note!

The information in this article is intended to inform you of some of the financial opportunities provided in the tax laws or elsewhere. It is not intended to give you specific advice for your personal situation. If you need such advice, please contact a qualified professional!