Premature Distribution

A premature distribution is any distribution taken from an individual retirement account (IRA), 401(k) investment account, tax deferred annuity, or other qualified retirement-savings plan that is paid to a beneficiary who is younger than 59.5 years old. Premature distributions are subject to a 10% early-withdrawal penalty by the IRS as a means of discouraging savers from spending their retirement assets prematurely.

There are several instances in which the premature-distribution penalty rules are waived, such as for first-time homebuyers, education expenses, medical expenses and Rule 72(t), which states that a taxpayer can take IRA withdrawals before they are 59.5, as long as they take at least five substantially equal periodic payments (SEPPs).

In 1997, Congress passed the Taxpayer Relief Act, which among other things, enabled taxpayers to withdraw up to $10,000 from tax-sheltered retirement accounts if that money is used to purchase a home for the first time. American policy makers were eager in the 1990s to enact policies that promoted homeownership, as they saw homeownership as the best means for promoting wealth accumulation. The bursting of the real estate bubble, and the trillions of dollars in savings lost as a result, has called into question the wisdom of these policies, but many such tax incentives for homeownership remain in the tax code.

Students can also withdraw funds early from their qualified retirement accounts if they use the proceeds for qualified higher education expenses. Qualified expenses include tuition, supplies, or books needed to attend an accredited institution of higher learning. Taxpayers cannot use funds withdrawn early for living expenses. Taxpayers can use funds they’ve withdrawn early for medical expenses as well. You can see a list of medical expenses approved by the IRS in publication 502. 

Rule 72(t) is another popular strategy for avoiding IRS-levied, early withdrawal fees. Rule 72(t) refers to the section of the tax code that exempts taxpayers from such fees if they receive those payments in Substantially Equal Periodic Payment. This means that you must withdraw your funds in at least five installments over five years, making this strategy less than ideal for those who need all their savings right away.

Congress has written in these exceptions in the tax code to support taxpayer behavior which it sees as in the public interest. While U.S. policy makers see promoting retirement savings as one of their top priorities, they have made exceptions in the cases of new homeowners or those overburdened with expenses related to schooling and medical care.