Early IRA Withdrawals

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, May 23, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

Question: I’m age 50 and withdrew IRA funds for medical expenses. My tax preparer says I must pay a 10% early-withdrawal penalty, in addition to income tax! Is this true?

Answer: No, although a portion of your IRA withdrawal could suffer taxes and penalties.

The 10% penalty for early withdrawal ("penalty") applies to IRA and Roth IRA distributions made to those under age 59 at the time of distribution, unless a specific exception applies. Withdrawals for deductible medical expenses, i.e. expenses exceeding 7.5% of your adjusted gross income ("AGI") are not penalized, whether or not you itemize deductions. The distributions must occur after 1997.

Example: Your AGI is $50,000, your maximum allowable deduction for medical expenses is $46,250 ($50,000 less 7.5% = $46,250) and you withdrew $48,000 from your IRA, then $1,750 would bear the penalty.

The penalty usually does not apply to IRA distributions used for health insurance premiums for yourself, spouse and dependents, provided you received unemployment insurance during the year or following year for at least 12 consecutive weeks. This rule also applies to self-employed individuals, except there is no requirement they receive unemployment insurance.

Question: May I withdraw IRA funds without penalty for education or the purchase of a home?

Answer: Yes, within strict limits. IRA distributions made after 1997 and used for "qualified higher education expenses" for yourself, spouse, or your or your spouse’s child or grandchild. Expenses are limited to tuition, fees, books, supplies and equipment in connection with post-high school education (including graduate courses) at a qualified educational institution. Scholarships and educational assistance received tax-free reduce the allowable qualified higher-education expense withdrawal.

Note: A qualified educational institution is described in section 481 of the Higher Education Act of 1965 and must be eligible to participate in a program under Title IV of such Act.

Example: Grandfather age 57 withdraws $10,000 from an IRA to pay his grand-daughter’s tuition in an MBA program. The entire program costs $20,000, including tuition, fees, books, supplies and equipment. Granddaughter receives a tax-free scholarship of $12,000. Grandfather will pay a penalty on $2,000 ($20,000 – 12,000 reduction for scholarship = $8,000 eligible for qualified educational expense; $10,000 withdrawn - $8,000 eligible = $2,000 excess subject to penalty). If grandfather were over the age of 59 when he made the withdrawal, the penalty would not apply.

Qualified first-time homebuyer IRA distributions also escape the penalty, but are limited to withdrawals totaling $10,000 during an individual’s lifetime. The home must serve as a principal residence of the taxpayer, spouse or any child, grandchild, or ancestor of the individual or spouse. The money may be used to buy, build or rebuild the home.

Note: A distribution from a Roth IRA which meets these rules is tax -- and penalty -- free, provided the funds have been in the Roth at least 5 years.

The "first" home means that the taxpayer or spouse must not have owned a principal residence within two-years prior to the purchase of the new home. The purchase date is when the contract to purchase is signed (not closing date) or construction begins. Should the acquisition or construction be terminated prematurely, the funds must be placed back in the IRA within 120 days to avoid tax and penalty.

Example: John, age 35, sold his home in 1995 to spend 4 years traveling. In May 1999, he contracts to purchase a home. He is entitled to withdraw $10,000 penalty-free from his IRA. If, however, John married Barbara who sold her home January 1998, he would not qualify as a first-time homebuyer, because his spouse would have sold a home within two years of John’s purchase.

Remember: Any IRA withdrawals prior to age 59 for medical, educational or first-time home expenses will always be subject to income tax under regular IRA tax rules, whether or not there is an early-withdrawal penalty.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**