The 59.5 Rule: Exceptions to the Withdrawal Penalty
Early distributions from a retirement account don't always mean a 10% penalty. Learn the specific circumstances that provide an exception to the IRS 59.5 rule.
Federal tax law establishes the age of 59.5 as a significant milestone for accessing retirement funds. The Internal Revenue Service (IRS) imposes a 10 percent additional tax on distributions taken from most tax-advantaged retirement accounts before an individual reaches this age. This regulation, often called the “59.5 rule,” is designed to encourage long-term savings by creating a financial disincentive for early withdrawals, helping to ensure funds are available during retirement.
Understanding the 10 Percent Additional Tax
The 10 percent penalty is an additional tax, levied on top of the ordinary income tax that is due on the withdrawal. For example, if an individual in the 22% federal income tax bracket takes a $20,000 early distribution from a traditional IRA, they would owe $4,400 in regular income tax plus an additional $2,000 for the early withdrawal penalty, totaling $6,400 in federal taxes. This does not include any applicable state income taxes, which would further reduce the net amount received.
This additional tax applies to the taxable portion of a distribution from a wide array of retirement plans. These include employer-sponsored plans like 401(k), 403(b), and governmental 457(b) plans, although distributions from 457(b) plans are exempt unless the funds were rolled over from another plan type. It also covers Individual Retirement Arrangements (IRAs), such as Traditional, SEP, and SIMPLE IRAs. For Roth IRAs, the penalty applies only to the withdrawal of earnings, not the contributions. A notable exception is within a SIMPLE IRA, where a withdrawal in the first two years of participation can trigger a higher 25% penalty.
Common Exceptions to the Early Withdrawal Penalty
While the 10 percent penalty is broadly applied, the tax code provides numerous specific exceptions that permit penalty-free access to retirement funds before age 59.5. One of the most significant is for distributions made due to death or a total and permanent disability. In the case of disability, a physician must certify that the condition is expected to be of long, continued, and indefinite duration. Another widely used exception is for a series of substantially equal periodic payments (SEPPs), which allows for withdrawals based on the owner’s life expectancy. The payment schedule must be maintained for at least five years or until age 59.5, whichever period is longer.
Financial hardships also create pathways for penalty-free withdrawals. An individual can take a distribution to cover unreimbursed medical expenses that exceed 7.5% of their adjusted gross income (AGI) for the year. Similarly, if someone is unemployed, they can use IRA funds to pay for health insurance premiums after receiving unemployment compensation for 12 consecutive weeks. The tax code also supports educational goals, allowing penalty-free withdrawals from an IRA to pay for qualified higher education expenses for the account owner, their spouse, children, or grandchildren.
Certain life events and specific plan types have unique rules. An IRA owner can withdraw up to a lifetime limit of $10,000 for a first-time home purchase. This can be used to buy, build, or rebuild a home for the owner or a qualifying family member, and the funds must be used within 120 days of withdrawal. A distinction exists for employees who separate from service with their employer; if this separation occurs in or after the year they turn 55, they can take distributions from that employer’s 401(k) or 403(b) plan without penalty. This “age 55 rule” does not apply to IRAs.
Other specific circumstances also qualify for an exemption. If the IRS places a levy on a retirement account to satisfy a tax debt, the resulting distribution is not subject to the 10 percent penalty. Qualified military reservists called to active duty for at least 180 days can take certain distributions penalty-free. Finally, distributions made from a workplace retirement plan under a Qualified Domestic Relations Order (QDRO) as part of a divorce settlement are also exempt from the penalty for the alternate payee.
How to Report an Exception
When a taxpayer takes an early distribution that qualifies for an exception, they must properly report it to the IRS to avoid the 10 percent additional tax. The primary mechanism for this is IRS Form 5329, “Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts.” This form is filed along with the individual’s annual income tax return, such as Form 1040. It is necessary even if the financial institution that issued the distribution did not note an exception on the Form 1099-R it sent to the taxpayer.
The process involves completing Part I of Form 5329, where the taxpayer reports the total distribution, the exempt amount, and a specific two-digit code from the form’s instructions that identifies the exception. For example, a distribution due to total and permanent disability uses code 03, while a withdrawal for a first-time home purchase uses code 09. A distribution taken as part of a series of substantially equal periodic payments is reported with code 02.