Most Americans that are lucky enough to have money stashed away for retirement in an Individual Retirement Account (IRA) are probably familiar with the age 59.5 rule, whereby a distribution from the IRA before that age will trigger not only taxes on the amount withdrawn, but a 10% penalty on early distributions.

In Pictures: 10 Retirement-Wrecking Moves

What is generally unknown is that the Internal Revenue Service (IRS) allows many exceptions to the 10% penalty tax on early distributions. These exceptions run the gamut from paying for college to buying a first home to helping with medical expenses.

Please note that the exceptions discussed in this article refer only to avoiding the 10% early-distribution tax, and that any funds withdrawn at any time from an IRA are taxable unless the funds are rolled over to another qualified plan.

Exception #1 – First-Time Home Buyers
We all know that the U.S. tax code loves homeowners, and individuals can avoid the 10% early distribution tax on up to $10,000 of distributions when the money is used to buy, build or rebuild a first home. This government largess extends not only to your own home, but also to a first-time home for your spouse, or your children or grandchildren.

The government also has a fairly loose definition of what constitutes a first-time homebuyer, which is defined as someone who has no "present interest" in a main home during a two-year period prior to the date of acquisition of the new home.

This $10,000 is cumulative, so you can't take $10,000 out every year to buy a first home for multiple children or other beneficiaries.

Exception #2 - Higher Education Expenses
The second exception is for distributions used to pay for qualified higher education (college) expenses, including tuition, books, fees and supplies. Not all expenses that are paid toward college are considered eligible and the IRS specifically mentions Pell grants and expenses paid from Coverdell Education Savings Accounts as not being covered. Once again the expenses can be for you, your spouse, children or grandchildren. (For more, check out our tutorial on Education Savings Account.)

Exception #3 – Medical Insurance
Individuals may also avoid the 10% early distribution penalty tax on funds taken out to pay medical insurance premiums. This exception applies only if you are unemployed and have been receiving unemployment compensation for 12 consecutive weeks. The distribution must be made either in the year you received that unemployment compensation, or the next year. The last condition that the IRS puts on this exception is that you must receive the distribution no later than 60 days after being reemployed.

Exception #4 – Unreimbursed Medical Expenses
Another exception exists for individuals with unreimbursed medical expenses. The amount of distributions covered under this exception are calculated as the amount you paid for these expenses less 7.5% of your adjusted gross income in that year.

Exception #5 – Disability
The final exemption is one for taxpayers who become disabled and take distributions before age 59 ½. These are not subject to the 10% penalty tax as long as a taxpayer can prove that they can't perform any "any substantial gainful activity" due to a physical or mental condition. This disability must either be of a "long, continued, and indefinite duration," or result in death.

Don't get cute with this one, as you can be sure if you claim this exemption, a visit from the IRS is certain.

Bottom Line
The conventional wisdom among most Americans is that money in an Individual Retirement Account (IRA) is locked up until age 59 ½, and can't be withdrawn without paying taxes and a 10% penalty on early distributions. The reality is that there are multiple exceptions to the 10% penalty that allows individuals to take money out for a range of reasons, including buying a first home to medical to education. (For more, check out our Investopedia Special Feature: Individual Retirement Accounts.)

Feeling uninformed? Check out this week's financial news highlights in Water Cooler Finance: Greece Attacks And Google Hacks.

Related Articles
  1. Retirement

    Roth 401(k), 403(b): Which Is Right for You?

    Learn how to decide between a traditional or Roth version of the 401(k), 403(b) or 457(b) retirement plans to help you build your nest egg.
  2. Retirement

    Going Back to Ecuador to Retire: A How-to Guide

    Spending your retirement years in Ecuador can be an affordable and attractive proposition, provided you know the country's laws.
  3. Retirement

    Is the New myRA Plan Right for You?

    The new myRA accounts seem to deliver on their promise of being “simple, safe and affordable.” Just be prepared for paltry annual returns.
  4. Credit & Loans

    Should I Use My IRA to Pay Off My Credit Cards?

    Cashing in an IRA to deal with outstanding credit card balances may not be the best way, but sometimes it's the best available way. Here's how.
  5. Investing Basics

    Fee-Only Financial Advisors: What You Need To Know

    Are you considering hiring a fee-only financial advisor or one who is compensated via commissions? Read this first.
  6. Retirement

    How Much Money Do You Need to Retire at 56?

    Who wouldn't want to retire early and enjoy the good life? The question is, "How much will it cost?" Here's a quick and dirty way to get an answer.
  7. Retirement

    The Best Strategies to Maximize Your Roth IRA

    If a Roth IRA makes sense for you, here are ways to build the biggest nest egg possible with it.
  8. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  9. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  10. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  1. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  2. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  3. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  4. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  5. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  6. Are catch-up contributions included in the 415 limit?

    Unlike regular employee deferrals, catch-up contributions are not included in the 415 limit. While there is an annual limit ... Read Full Answer >>

You May Also Like

Trading Center