Options for IRA Hardship Withdrawals

Ordinarily if you withdraw money from a traditional individual retirement account before retirement age, you can see a tax penalty. But there are exceptions that let you take a penalty-free IRA withdrawal in certain hardship situations. You can also move money between IRAs without paying tax or a penalty.

Contributing to an IRA

An IRA is an account that you can contribute earned income to while you're working, receiving a tax deduction for the amount you contribute to the account. Unlike a 401(k) or 403(b) plan that your employer must open for you, you open an IRA for yourself with a bank or brokerage of your choice.

You generally can contribute up to $5,500 to your IRAs every year, or up to $6,500 if you're 50 or over. The money you contribute can't be more than you and your spouse made that year.

Withdrawing From an IRA

When you reach age 59 1/2, you can withdraw from your IRA, paying tax on the money you withdraw at your then-current tax bracket rate. If you withdraw money before age 59 1/2, you must pay the tax you owe at your ordinary income rate plus an additional 10 percent tax penalty.

Certain exceptions let you avoid the tax penalty, but you'll generally always owe tax unless you have sufficient deductions and credits to offset it.

You can also transfer money to a new IRA without penalty, provided you follow the Internal Revenue Service rules.

Penalty-Free IRA Withdrawal Rules

If you're under 59 1/2, you can withdraw from your IRA without penalty if certain conditions apply.

If you're unemployed, you can use IRA money without penalty to pay for health insurance for yourself and your family. You can also pay certain higher education expenses for yourself and your family using IRA money without having to pay a tax penalty.

If you're called to active military duty as a member of the military reserves or the National Guard, you can often withdraw money without penalty. If you're permanently and totally disabled or you're paying healthcare expenses in excess of 7.5 percent of your IRS adjusted gross income, you can also take from your IRA without paying a penalty.

First-time homebuyers, as defined by IRS rules, can also withdraw up to $10,000 without a penalty to use toward the purchase of that home.

How Roth IRAs Work

Roth IRAs are a special type of IRA that function differently from traditional IRAs. When you put some of your income into a Roth IRA, you pay tax on the money as usual. The IRA contribution limit applies to all of your traditional and Roth IRAs.

When you withdraw from a Roth IRA after turning 59 1/2, you don't pay any additional tax on the money that you withdraw. That includes any investment gains, meaning your Roth IRA effectively earns money tax-free until you're at retirement age. This can be advantageous if you're anticipating large gains or being in a higher income tax bracket when you retire.

You can convert a traditional IRA into a Roth IRA by working with the company that manages it to effectively pay the deferred tax on the account.

Early Roth IRA Withdrawals

You can withdraw money you put into a Roth IRA at any time without paying tax or a penalty, though you will lose the advantage of further tax-free growth.

Tax-free IRA withdrawals from a Roth account are limited to what you contributed, however, so if you withdraw investment earnings early you must pay ordinary income tax and the 10 percent penalty on what you withdraw. If one of the exceptions applies as would with a traditional IRA, you can pay only the income tax.

IRA Rollover Rules

If you want to transfer money from one IRA to another, it's usually best to have one financial institution move the money directly to another without it going into your possession.

If you take possession of the money, you must put it into a new IRA within 60 days or owe the tax and penalty for withdrawing it. Certain hardship exceptions can apply if you can't deposit the money in time because of illness, a family emergency or because of an error by your financial institution.

Additionally, you often will face a 20 percent withholding tax which you must make up for with your own funds or be considered to have withdrawn that money. There's also a limit of one indirect IRA rollover within a year period to prevent people from continually rolling over funds to effectively take a loan from an IRA, which is not allowed.

401(k) Early Withdrawal Exceptions

The circumstances where you can withdraw money early from a 401(k) or 403(b) retirement account are much narrower than with a traditional IRA. These are accounts that your employer will set up for you and you will usually fund with regular deductions from your pay.

Military reservists can take penalty-free withdrawals, as can disabled people and people with medical expenses above 7.5 percent of adjusted gross income. But first-time homebuyers, people who need health insurance while unemployed and people paying high education expenses are all out of luck when it comes to a 401(k). If the IRS seizes your money for unpaid taxes as part of a tax levy, you won't face additional taxes if it comes out of a 401(k) account.

This is one reason to roll over a 401(k) to an IRA when you leave a job, along with the fact that many IRAs offer a wider range of investment options than 401(k) plans do. Once the money is in an IRA, the IRA hardship rules will apply, not the 401(k) rules.

Taking a 401(k) Loan

Unlike an IRA, you can take a loan from a 401(k) if your plan allows it. You generally have to pay the loan back within five years, unless you're taking the money to buy a main residence, and you must pay interest at a reasonable interest rate, although the interest goes back into your account.

Generally, you can't borrow more than $50,000 and you can't borrow more than half of your account balance. One exception: If you have less than $20,000 in the plan, you can borrow up to $10,000 if the plan allows it.

If you leave your job, you may be required to pay back the loan faster, and your loan payments and interest aren't tax deductible the way IRA and 401(k) contributions normally are.

If you fail to pay the loan back on schedule, you can be considered to have taken an early withdrawal from the 401(k), and you will owe the usual tax and 10 percent penalty.

Required Minimum Distributions

Once you reach age 70 1/2, you must begin withdrawing from traditional IRAs and 401(k) accounts or you will face a hefty tax penalty. The IRS publishes tables you can use to calculate your mandatory withdrawals, known in tax jargon as required minimum distributions, based on your account balances and your age.

If you don't take the required distributions, you can be required to pay a tax penalty equal to 50 percent of the difference between what you withdrew and what you were required to withdraw. This is more than you'd owe under any current tax bracket on your IRA withdrawals.

Roth IRAs don't have required minimum distributions. Special rules apply if you inherit an IRA, whether it's a traditional or a Roth account.

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About the Author

Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.


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