Qualifying for an IRA Hardship Withdrawal After Job Loss

An Individual Retirement Arrangement (IRA) is a tax-advantaged retirement savings account. Accessing these funds before retirement age results in financial drawbacks. For those who have recently lost their job, the need for funds can become urgent, making an early IRA withdrawal seem necessary. This guide provides information for individuals considering tapping into their retirement savings.

Financial Consequences of Early IRA Withdrawals

Taking a distribution from a traditional IRA before age 59 ½ has immediate tax implications. The entire amount withdrawn is added to your gross income for that year and taxed at your personal income tax rate, which can push you into a higher tax bracket.

Beyond the ordinary income tax, the Internal Revenue Service (IRS) imposes an additional 10% tax on early distributions. This penalty is meant to discourage the premature use of retirement funds. The 10% tax is calculated on the taxable portion of the withdrawal and is applied on top of the regular income tax you owe.

The combined effect of income tax and the 10% penalty can substantially diminish the funds you access. For instance, if you are in the 22% federal tax bracket and withdraw $20,000 from your traditional IRA, you would owe $4,400 in federal income tax. The additional 10% penalty would be another $2,000, resulting in a total tax and penalty of $6,400. This would leave you with only $13,600 of the original $20,000 withdrawal.

Qualifying for a Penalty Exception Due to Job Loss

Job loss itself is not a direct exception to the 10% early withdrawal penalty for IRAs. The tax code does not list unemployment as a qualifying reason to waive the penalty. However, an individual who has lost their job may qualify through other specific exceptions that are often associated with unemployment.

The most directly related exception is for paying health insurance premiums. To qualify, an individual must have received federal or state unemployment compensation for 12 consecutive weeks. The withdrawal must be made in the same year the unemployment benefits were received or in the following year. The penalty-free withdrawal amount cannot be more than the total amount you paid for health insurance for yourself, your spouse, and your dependents.

Another exception is for unreimbursed medical expenses. You can take a penalty-free distribution for medical costs that exceed 7.5% of your adjusted gross income (AGI) for the year. A significant medical event combined with a lower AGI from unemployment could make this exception applicable.

A more severe situation that may coincide with job loss is becoming totally and permanently disabled. The IRS defines this as being unable to engage in any substantial gainful activity because of a physical or mental condition. A physician must determine that the condition is expected to be of long, continued, and indefinite duration or lead to death. If this standard is met, any amount can be withdrawn from the IRA without the 10% penalty.

Information and Documentation for the Withdrawal

Before initiating a withdrawal, gather the necessary information for your IRA custodian. You will need your account number, personal details for identity verification, and the specific dollar amount you plan to withdraw.

To substantiate a claim for a penalty exception, specific documentation is required. If you are claiming the exception for health insurance premiums, you must retain proof that you received unemployment compensation for 12 consecutive weeks. This can include benefit statements or letters from your state’s unemployment agency. You will also need to keep invoices, bank statements, or canceled checks as proof of the health insurance premiums you paid.

The Withdrawal and Tax Reporting Process

The first step is to contact your IRA custodian to request the distribution, which can be done online, by phone, or with a withdrawal form. You will state the amount you wish to withdraw and may have the option to have federal and state taxes withheld directly from the distribution.

After the custodian processes your request, the funds will be sent to you via direct deposit or a check. Early in the following year, you will receive IRS Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” from your custodian. This form is important for tax reporting; it will show the gross amount of your distribution in Box 1 and will likely have distribution code ‘1’ in Box 7, which signifies an early distribution with no known exception to the custodian.

The final step is to address the penalty when you file your annual tax return. Because your Form 1099-R will likely indicate an early withdrawal, you must file Form 5329, “Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts,” with your Form 1040. On this form, you will report the total withdrawal amount, subtract the portion that qualifies for an exception, and enter the appropriate exception code. For a withdrawal to pay health insurance premiums while unemployed, the code is ’07’, and for unreimbursed medical expenses, the code is ’05’.