Can You Avoid the 10% Early Retirement Penalty? 10 Possible Ways

Not surprisingly, people want to make sure they have the income to last throughout their lifetimes. If you plan well, you could theoretically retire at age 55, 50, 45 or sooner. Maybe you’ve sold your business for profit, you’ve maximized your retirement account contributions for years, you’ve invested in non-qualified accounts, and you own multiple rental properties. At that point, you could take a blended distribution from various accounts and investments so that your money continues to grow tax-sensitive to you. However, if you take distributions from your retirement accounts before age 59 ½, many times, you will owe the IRS a 10% early distribution penalty. Sometimes, though, the government will waive that 10% early retirement penalty if certain conditions are met.

Let me explain.

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Podcast Time Index for “How to Retire Before 59.5 and Not Pay 10% Penalty”

• 01:07 – How Do I Take Income From My Retirement Accounts?
• 04:06 – The 59 ½ Rule
• 04:48 – IRA Withdrawal for Medical Expenses
• 06:31 – IRA Withdrawal to Pay for Health Insurance
• 07:50 – IRA Withdrawal for a 1st Time Home Purchase
• 08:35 – If You Are Disabled
• 09:06 – The 72 T Calculation
• 10:58 – Leave The Money in The 401K
• 11:38 – 401K Loan
• 12:32 – An Inherited IRA
• 13:27 – ROTH IRAs
• 15:58 – Wrap Up

Before I go any further, let me make one thing clear. I’m writing about ways you might be able to avoid the 10% income tax penalty. That’s all you’re trying to do. If you take money out of your qualified retirement accounts early, you will still pay ordinary income taxes on that money. You cannot avoid that.

10 Possible Ways to Avoid the 10% Early Retirement Penalty

#1 – IRA Withdrawal for Medical Expenses

Sometimes, unexpected medical bills arise. Usually, you can’t predict when you’ll need surgery, be hospitalized, or be in an accident. As if to add salt to your wounds, you’re likely to incur significant medical expenses when you experience medical emergencies. Sure, your health insurance might offset some of those costs. Yet most likely, you’ll still owe hundreds or thousands of dollars out-of-pocket after insurance pays its portion. What do you do if you’re on a tight monthly budget? How do you pay for those expenses if billing companies won’t accept small monthly payments?

Well, you can actually make a withdrawal from your traditional IRA for significant medical expenses without having to pay the 10% early withdrawal tax penalty if you’re under the age of 59 ½. Yet, there are a couple of catches. Obviously, you wouldn’t withdraw tiny amounts of money from your IRA for medications or doctors’ visits here and there. No, you’d pay those expenses from your normal monthly budget. To withdraw money and avoid the 10% penalty, your medical expenses must exceed 10% of your adjusted gross income. Additionally, you must use the money to cover expenses that your health insurance did not cover.

#2 – IRA Withdrawal to Pay for Health Insurance

Along the same lines, you can pay for health insurance premiums by using IRA dollars if you meet certain conditions. IF you lose your job AND collect unemployment compensation for 12 consecutive weeks, you can take IRA money to pay for health insurance for you, your spouse, and/or your dependents. Yet, there’s one more catch. In order to do this, you MUST take the distribution within the year you receive the unemployment compensation.

#3 – IRA Withdrawal for a First Home Purchase

Another time you can take an early withdrawal from your IRA and avoid the 10% penalty is for a first home purchase. Sure, you may be retiring, but maybe you’ve never owned a home. Perhaps you’ve rented apartments or houses your entire life due to work-related travel, commutes, or other circumstances. Maybe you’ve lived in a house you inherited from a family member. If you’re buying or building your first home, you can withdraw $10,000 if you’re single or $20,000 if you’re married (if you both have IRA’s) from your traditional IRA.

#4 – IRA Withdrawal for Disability

Unfortunately, many of my clients have had to take early distributions from their IRAs because they became disabled. If you become disabled, you may be eligible for SSDI and/or SSD benefits. Yet, “most SSDI recipients receive between $800 and $1,800 per month” with the average for 2019 at only $1,234 per month. If you’re a business owner, you’re probably used to taking home much more than that in your monthly budget. Therefore, if you become disabled AND you have a physician who signs off on the severity of your condition, you can take money out of your IRA penalty-free to supplement your SSD income. As awful as that is to think about, at least you know it’s a possibility.

#5 – IRA Withdrawal through a 72(t) Calculation

According to Rule 72(t), section 2 of the Internal Revenue Code, IRA owners can withdraw funds penalty-free IF they take them as annuity payments over the course of their lives. To do this, you must have an actuary run calculations to determine what the substantial equal periodic payments (SEPPs) will be. Additionally, you must take the payments for either five years or until you turn 59 ½, whichever is greater.

#6 – 401(k) Withdrawals

Now, we’re going to get out of IRAs for a little bit and look at 401(k) accounts. Let’s say you have a 401(k) at your job, but you leave that job or retire from it between the age of 55 and 59 ½. If you keep your money in the 401(k) and do not roll it into an IRA, you can withdraw funds from the account without having to pay the 10% penalty. Just remember, you have to be between 55 and 59 ½ years old.

#7 – 401(k) Loans

Another technique you can use is taking a loan from your 401(k). Loan provisions apply to 50% of your account balance up to $50,000. Thus, if you have an account at work that has $100,000 or $200,000 in it, you can take $50,000 out in a loan. If you have $20,000, you’re only going to be able to get $10,000 out of that 401(k).

I actually used this with a client one time. He retired at 58-years-old, only one year from 59 ½. He needed a little bit of money, so he went in and borrowed money through a loan provision in his work 401(k). Instead of paying taxes on his withdrawal at the time he took the loan (because he was in a much higher tax bracket because of his pre-retirement income), he waited until he rolled over the 401(k) into an IRA at 59 ½. Then, he paid taxes on that rollover.

#8 – Inherited IRA Withdrawals

I’m starting to see inherited IRAs more often. Let’s say that your parents or an aunt or uncles passes away and leaves you an IRA for an inheritance. If you receive that before you are 59 ½ years old, you can take the money out of that inherited IRA penalty-free. Of course, you’re going to pay ordinary income tax on it, but you’re not going to pay a 10% early distribution penalty on an inherited IRA.

#9 – ROTH IRA Contribution Withdrawals

Any money you put into a ROTH IRA is after-tax money. Because you’ve already paid taxes on that money, you can pull your contributions out of the ROTH IRA tax-free and penalty-free any time. You can’t take your earnings out before age 59 ½ or before the earnings have been in the account for five years. However, you can always take your contributions out.

#10 – ROTH IRA Qualified Education Expense Withdrawals

Finally, you can pull money out of your ROTH IRA to pay for qualified education expenses for yourself or for your dependents. As just discussed, you can always pull your contributions out, but you can also pull your earnings out early and penalty-free if you follow a certain set of rules.

If you’re blessed enough to be able to retire early, make sure you let your pre-planning work for you. You want to have enough income to last throughout your lifetime. Yet, you also need protection from events as they happen in your life. Whether you need to cover unexpected medical bills or send your children to college loan-free, know your options. Although you can’t avoid paying ordinary income taxes on early retirement account withdrawals, there may be times you can avoid paying a 10% penalty.

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