Eleanor Finch
A hardship withdrawal is an emergency removal of funds from a retirement plan, typically in response to an immediate and heavy financial need. While IRAs and IRA-based plans do not offer participant loans, there are certain scenarios where you can make a penalty-free withdrawal from your IRA. These include unreimbursed medical expenses, higher education expenses, first-time home purchases, and birth or adoption expenses.
| Characteristics | Values |
|---|---|
| Age limit for early withdrawal penalty | 59.5 years old |
| Additional tax on early withdrawal | 10% |
| Waiver of additional tax | Death, total and permanent disability, medical expenses, higher education expenses, first-time home purchase, active military duty, birth or adoption expenses |
| Maximum withdrawal for first-time home purchase | $10,000 |
| Maximum withdrawal for birth or adoption expenses | $5,000 |
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What You'll Learn
Unreimbursed medical expenses
Generally, withdrawing funds from an IRA before reaching the age of 59 1/2 is considered an early withdrawal and may trigger a 10% penalty. However, there are exceptions to this rule, and certain circumstances may qualify you for a hardship withdrawal from your IRA without incurring a penalty.
It is also worth mentioning that, while you can avoid the 10% early withdrawal penalty for unreimbursed medical expenses, you may still owe income tax on the withdrawal amount. This is because traditional IRAs are tax-deferred savings vehicles.
To summarise, unreimbursed medical expenses that exceed the threshold of 7.5% or 10% of your AGI can qualify for a penalty-free hardship withdrawal from your IRA. However, you must ensure that you take the withdrawal and use it to pay for the medical expenses within the same calendar year. Even with this exception, you may still be subject to income tax on the withdrawn amount.
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Higher education expenses
A hardship distribution is a withdrawal from a participant's elective deferral account due to an immediate and heavy financial need, limited to the amount necessary to satisfy that need. The IRS considers a hardship distribution to be an emergency removal of funds from a retirement plan, such as an IRA, in response to an immediate and heavy financial need.
The IRS allows you to take early withdrawals from your traditional IRA penalty-free to cover qualified higher education expenses at postsecondary schools. This includes any education beyond high school, including vocational schools. You can use the hardship distribution to pay for qualified higher education expenses for yourself, your children, or other immediate family members.
To avoid penalties, you must only withdraw the amount necessary to cover your financial need. Additionally, you must report your IRA withdrawals for education on your tax return and fill out Form 5329 to note your higher education exception.
It is important to note that while a hardship distribution from an IRA for higher education expenses is exempt from the early distribution tax, you will still owe income tax on the withdrawal amount. This is because traditional IRAs are tax-deferred savings vehicles, meaning you owe income tax on any withdrawals.
Before deciding to take a hardship withdrawal from your IRA for higher education expenses, consider the financial implications and explore all the rules and alternatives. For example, a Substantially Equal Periodic Payments (SEPP) plan can help you avoid the 10% early withdrawal penalty. Additionally, a 529 college savings plan offers several tax breaks, allowing you to withdraw money tax-free at any time to pay for qualified higher education expenses.
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First-time home purchases
The IRS considers buying a home to be a "hardship", and so hardship withdrawals are an option for first-time home purchases. However, there are some important things to consider. Firstly, hardship withdrawals are subject to income tax and a 10% early withdrawal penalty. You will also have to wait six months after the withdrawal before you can start contributing to your 401(k) again.
If you are considering withdrawing from a Roth IRA, you can withdraw your contributions at any time without penalty or tax. However, you must pay taxes on any earnings that are withdrawn unless your Roth IRA has been open for at least five years. If you are under 59 and a half years old, you can withdraw up to $10,000 from a traditional or Roth IRA without the 10% penalty, as long as the money is used for a first-time home purchase. If you withdraw more than $10,000, the 10% penalty will be applied to the additional amount, and you will also have to pay income tax on the entire withdrawal.
One strategy is to take advantage of rollover rules. This involves withdrawing money from your IRA, using it for your house, and then repaying it within 60 days. However, unless you are confident that you will be able to repay the "rollover" within 60 days, you may end up owing an early withdrawal penalty.
Another option is to take out a loan from your 401(k) account. You can borrow up to $10,000 or half of your vested account balance, whichever is lower. You will not incur the early withdrawal penalty and will not have to pay income tax on the amount you borrow, but you will have to pay it back with interest.
Before deciding on a hardship withdrawal, it is important to consider the opportunity cost. $10,000 withdrawn from a traditional IRA may only amount to $8,800 or less after taxes, and that money could be worth much more in retirement savings. For example, $20,000 in a 401(k) account could grow to over $100,000 in 25 years with a 7% annualized return.
In conclusion, while hardship withdrawals are an option for first-time home purchases, there are tax and penalty implications, and it may not be the best financial decision in the long term. It is recommended that you consult a financial advisor for personal guidance before making a decision.
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Military reservists
To qualify for this type of hardship withdrawal, a military reservist must be called to active duty for at least 180 days or an indefinite period, and this must have occurred after September 11, 2001. It is important to note that only certain types of distributions are exempt from the extra 10% tax. For example, if the taxpayer is over 59 ½, they would not be subject to the additional 10% tax, regardless of their military status.
After returning from active duty, military reservists have the option to repay part or all of the withdrawn amount back into their retirement plan. They have up to two years from the end of their active duty service to make this repayment without being subject to yearly contribution limits.
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Total and permanent disability
To qualify for this exemption, an individual must meet the Internal Revenue Service's (IRS) definition of total and permanent disability. According to the IRS, an individual is considered totally and permanently disabled if they have a physical or mental impairment that renders them unable to perform any substantial gainful activity, or work, for an extended period or indefinitely. The condition is expected to be of "long, continued, and indefinite duration" or result in death. It is important to note that being classified as disabled by other agencies, such as Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI), does not guarantee eligibility for the IRS's disability exception.
To claim the disability exemption to the early withdrawal penalty, individuals must complete and submit IRS Form 5329 with their federal tax return for the year. While it is not mandatory to submit a doctor's statement with the tax return, it is essential to have one in your possession. This statement should confirm that the individual's condition is terminal or will result in an indefinite period of disability. The doctor's opinion must be obtained before taking the distribution from the retirement plan and must specify that the individual is unable to work due to their physical or mental disability.
It is worth mentioning that there are other criteria for hardship withdrawals from IRAs, such as unreimbursed medical expenses exceeding 7.5% of adjusted gross income (AGI), qualified higher education expenses, and certain expenses related to natural disasters. These withdrawals must be made during the same calendar year that the expenses are incurred to avoid the 10% early withdrawal penalty. Additionally, hardship withdrawals are typically limited to the amount necessary to satisfy the immediate and heavy financial need.
While IRAs offer flexibility in withdrawing funds at any time, it is important to consider the potential tax implications and penalties associated with early withdrawals. In the case of total and permanent disability, the IRS provides an exemption from the standard 10% penalty, allowing individuals to access their retirement savings without incurring additional financial burdens during challenging times.
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Frequently asked questions
A hardship withdrawal is an emergency removal of funds from a retirement plan, in response to an immediate and heavy financial need. This can be done without penalty, but the distribution will be subject to standard income tax unless it's a Roth account.
The IRS allows penalty-free hardship withdrawals from an IRA to cover certain expenses, including unreimbursed medical expenses, health insurance premiums (if unemployed), higher education expenses, and first-time home purchases.
A hardship withdrawal from an IRA is generally taxed as ordinary income. If done before the age of 59 1/2, there is also a 10% early withdrawal penalty, unless you qualify for an exception.
