Who Can Use a 10% Penalty Exception?

By Andy Ives, CFP®, AIF®
IRA Analyst

As a follow up to the March 26 Slott Report entry that included a full list of the 10% early withdrawal penalty exceptions (“10% Penalty Exceptions: IRAs and Plans”), here we get a little deeper into the weeds on some of the nuances of certain exceptions. As mentioned in the March 26 article, some exceptions apply to plans only, some to IRAs only, and some to both. Taking that concept a bit further, some exceptions apply to the account owner only, and some to certain extended family members of the account owner.

Not only must a person know which exceptions apply to which accounts, but they must also recognize who can leverage these exceptions. We have seen countless situations where a misunderstanding has led to the exception being denied. For example, in a recent court case, an IRA owner under the age of 59½ took a distribution from his account and claimed the disability exception. He used the dollars to cover expenses for his disabled wife. And therein lies the problem. The disability exception is applicable to the IRA owner only. Even though the distributed money was used to cover the legitimate costs for taking care of a disabled person (the wife), the IRA owner (husband) was not disabled. To qualify for the exception, the withdrawal needed to come from the disabled wife’s account. The 10% penalty exception was denied.

Like the disability exception, other exceptions available to the account owner ONLY include birth or adoption, terminal illness, active reservists, age 55, and the 72(t) substantially equal periodic payment exception. Meaning, the account owner himself must be the one who is terminally ill or adopting a child. Other exceptions are applicable to the account owner AND certain extended family members. These include the following:

• Higher Education (IRAs only). The 10% penalty on the IRA distribution can be avoided if the higher education costs are for the IRA account owner, his spouse, child, or grandchild of either the owner or spouse. Nephews, cousins and siblings of the IRA owner do not qualify.

• First-Time Homebuyer (IRAs only). For the purchase of a home belonging to the IRA owner, his spouse, any child, grandchild, or ancestor of the IRA owner or his spouse. Again, people like nephews, cousins and siblings of the IRA owner do not qualify.

• Medical Expenses over 7.5% of adjusted gross income (Plans and IRAs). This exception is used for expenses incurred by the account owner, spouse or dependent. Just be careful with timing. The medical expenses must be paid in the same year as the distribution.

• Domestic Abuse (Plans and IRAs). The IRA owner himself does not need to be the victim to qualify for this exception. The abuse could be inflicted on the account owner’s child or another family member living in the household.

• Financial Emergencies (Plans and IRAs). This exception is for distributions necessary to meet “unforeseeable or immediate financial needs relating to personal or family emergencies.” Hence, it is available for a family member’s emergency, not just those of the account owner.

If you have technical questions you would like to have answered, be sure to submit them to [email protected], to be answered on an upcoming Slott Report Mailbag, published every Thursday.