Accessing IRA Assets Early: Know the Options, Consider the Ramifications
By Agatha Schmidt, CISP, SDIP, CHSP
The coronavirus (COVID-19) pandemic has undoubtedly affected not only the health of millions of Americans—and cost the lives of thousands—but also their financial well-being. Lockdowns and stay-at-home orders nationwide have resulted in businesses closing their doors temporarily or, in some cases, permanently. The U.S. unemployment rate peaked in the early months of the pandemic and is not expected to return to pre-pandemic levels until 2024, according to the Congressional Budget Office’s report, “The Budget and Economic Outlook: 2021–2031.” Additionally, those affected severely by the disease may be left with medical and hospital bills amounting to tens of thousands of dollars, if not more.
With the economic downturn and individuals facing unemployment, large medical bills, or both, some may have no choice but to dip into their retirement savings. And if they have an IRA, they can; IRA assets are always available to the IRA owner. But retirement savings are meant to be used for, well, retirement. Taking an IRA distribution too early may result in penalties, specifically the 10 percent early distribution penalty tax if the IRA owner is under age 59½.
Penalty Exceptions
Fortunately, the IRS provides some exceptions to the early distribution penalty tax, a few of which may apply to IRA owners under age 59½ who needed to or will need to access their IRA assets early.
Health Insurance Premiums Following Unemployment
For continued health insurance coverage following unemployment, individuals may elect to be covered under COBRA or purchase their own health insurance. These premium payments are typically paid out-of-pocket. The 10 percent penalty tax will not apply to IRA distribution amounts that do not exceed amounts paid for insurance coverage while receiving unemployment compensation for at least 12 consecutive weeks.
Medical Expenses
The 10 percent penalty tax will not apply to IRA distributions that do not exceed amounts of unreimbursed medical expenses that are more than 7.5 percent of the IRA owner’s adjusted gross income (AGI) for the year of the IRA distribution. The unreimbursed medical expenses can be those of the IRA owner, her spouse, or her dependents. Only the expenses that are deductible as an itemized medical expense deduction on Schedule A, Form 1040, U.S. Individual Income Tax Return, can be taken into account (however, the individual does not need to itemize her deductions to qualify for this penalty tax exception).
Substantially Equal Periodic Payments
Another way to access IRA assets without incurring the early distribution penalty tax is to set up up a series of substantially equal periodic payments. These payments, taken at least annually, must continue unchanged for at least five years or until the IRA owner reaches age 59½, whichever is later. For someone looking to supplement their income during a period of temporary unemployment or someone who is considerably younger than the age threshold, this may not be the best option, as they would be “locked in” to taking the distributions for a substantial period of time. The consequence of modifying or ending the series of payments before the required time period is up is retroactive taxation—the 10 percent penalty tax, plus interest, would apply to all of the distributions, beginning with the first payment.
Coronavirus-Related Distributions
The Coronavirus Aid, Relief, and Economic Security (CARES) Act allowed for coronavirus-related distributions (CRDs) of up to $100,000 on or after January 1, 2020, and before December 31, 2020, by qualified individuals—amounts to be taxed equally over three years unless full 2020 taxation is elected. These distributions are also exempt from the 10 percent penalty tax. “Qualified individual” includes someone who himself or a member of his household has been diagnosed with the COVID-19 virus, or experienced financial hardship as a result of being quarantined or having their job or working hours affected by the COVID-19 pandemic. If their financial situation allows for it, individuals who qualified for a CRD may want to take advantage of the three-year repayment option to keep their retirement nest egg growing.
Roth IRA Flexibility
Those who own a Roth IRA may not have to rely on a penalty exception to access money from their Roth IRAs early. Under the ordering rules for Roth IRA distributions, contributory assets come out first and are always tax- and penalty-free. Any converted assets or assets rolled over from a non-Roth qualified retirement plan come out next, and, unless the conversion or rollover took place less than five years before the distribution, are also tax- and penalty-free. Earnings come out last—after the contributory and conversion assets have been depleted—and, if not considered “qualified,” are subject to income tax. Thus, if a Roth IRA owner is under age 59½ and withdraws nonqualified earnings from her Roth IRA without a penalty tax exception, the 10 percent penalty tax applies to those earnings. Although withdrawing assets from a Roth IRA may result in minimal tax-related consequences, those contemplating this option should consider the consequence of losing their earning potential over time.
Legislation makes it clear that IRA assets are meant for retirement. But in certain circumstances, such as these unprecedented times, lawmakers understand that people may need to access their retirement savings early to stay afloat financially, especially to pay for continued health insurance coverage, pay for unforeseen medical expenses, or supplement their income during a period of unemployment. But the decision to access any type of retirement savings early should not be taken lightly, as most Americans will come to depend on their hard-earned savings to provide income in their golden years.
Please see the companion article in this issue of The Link, which addresses taking early distributions from 401(k) plans.
