Life happens. Many investors have found themselves needing to tap into an IRA because of a short-term financial crunch, purchase a first-time home for themselves or a family member, or fund college costs. Under normal circumstances, withdrawals from both self-directed IRAs and conventional IRAs are subject to a substantial 10 percent excise tax if made prior to age 59½. Congress enacted the painful penalty to ensure that taxpayers would truly treat their IRAs as long-term investment vehicles rather than short-term tax-advantaged playthings.
But they were also realistic: They anticipated that people would occasionally need to access their retirement funds for financial emergencies. They also believed that if they didn’t cut people a break on the 10 percent penalty under some circumstances, or allow access to their money, people would be less likely to actually contribute to IRAs. This would defeat the whole purpose behind IRAs and self-directed IRAs: To help secure a retirement income for the taxpayer and his or her family.
Self-Directed IRA Hardship Withdrawals
The rules for self-directed IRA hardship distributions are the same as those for conventional traditional IRAs. You can access your principal and any growth from deductible contributions by paying income tax on the distribution, but the 10 percent penalty is waived under the following circumstances:
- The disability of the taxpayer.
- When the withdrawal is necessary to avoid foreclosure or eviction.
- To pay health insurance premiums (if you’ve been unemployed for at least 12 weeks).
- To make a down payment on a home for a first-time homebuyer (up to a lifetime limit of $10,000). For the purposes of administering the rules on IRAs or self-directed IRAs, a first-time homeowner is one who has not owned a home in the previous two years.
- To pay for higher education for the IRA owner or a family member.
- To pay unreimbursed medical bills (in excess of 10 percent of the taxpayer’s adjusted gross income).
- IRS levies against the IRA. If the IRS levies your account to pay unpaid taxes, you won’t be charged a penalty. But you will have to pay income taxes on the amounts they take from a traditional IRA or traditional self-directed IRA.
- As part of a series of substantially equal periodic withdrawals. In other words, if you want to retire early, you can begin accessing your IRA penalty-free as long as you commit to taking it out in a steady stream of monthly or annual payouts based on your life expectancy or the combined joint life expectancy of you and your designated beneficiary.
Roth IRAs, including self-directed IRAs, have similar hardship distribution rules. The main difference is that any principal you have contributed and that has remained in the account for at least five years can be withdrawn tax-free and penalty free. The taxes and penalties only apply to the growth attributable to that money, as well as to contributions that have been made within the last five years.
Self-Directed IRA Hardship Withdrawals vs. 401(k)s
From the perspective of flexibility in the event of financial hardships, IRAs are generally superior to 401(k)s, as 401(k)s do not have these hardship exceptions. In fact, some 401(k) plan sponsors do not allow for in-service withdrawals for any reason, or they may make you jump through hoops before you can access your money.
Furthermore, your plan administrator will automatically withhold 20 percent of the amount you withdraw from a 401(k) and forward it to the IRS against taxes. However, if you have penalties to pay, you will have to pay income taxes on the entire amount withdrawn, even for the amounts you never receive because they’ve been forwarded to the IRS.
For this reason, if you have a 401(k) from a former employer, and you anticipate the need to make a hardship withdrawal in the future, or if you just want much more flexibility on what you can invest it in and to reduce the amounts you pay in fees, it may well make sense to roll your 401(k) over to an IRA with American IRA, LLC.