Smart Strategies for Qualifying for Early Distribution Penalty Exceptions.

Early—or pre-age 59½—distributions from IRAs and employer plans are subject to a 10% early distribution penalty unless an exception applies. In Part 1, we explain how to avoid losing eligibility for some exceptions by changing from one type of plan to another. In Part 2, we highlight some of the rules to consider when navigating certain exceptions.

Caution: the rate increases to 25% for some SIMPLE IRAs

If a pre-age 59½ distribution is made from a SIMPLE IRA that has not been funded for at least two years, the early distribution penalty rate increases from 10% to 25%. This two-year period starts when the first SIMPLE IRA contribution is made to the employee’s SIMPLE IRA.

Smart strategy: Avoid taking early distributions from SIMPLE IRAs during the two-year period as the cost is steep. If an unavoidable need for funds arises, the participant may take a distribution from another type of account if possible.

A dollar cap applies in some cases

Some exceptions are subject to a dollar limit. Here are a few examples:

• The first-time homebuyer exception has a lifetime limit of $10,000 per IRA owner.
• Any qualified birth or adoption distribution is capped at $5,000 per child of the participant.
• Any eligible distribution to a domestic abuse victim is capped at $10,000 (indexed) per participant ($10,300 for 2025).

On the other hand, some exceptions are not subject to a cap- examples include distributions that qualify for the disability and terminally ill exceptions.

Smart strategy: An IRA owner has 120 days to use a qualified first-time homebuyer distribution to pay qualified acquisition costs for the IRA owner or eligible family members. Qualified acquisition costs include the costs of acquiring, constructing, or reconstructing a principal residence. For this purpose, a first-time homebuyer is someone—and their spouse if married—had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition of the principal residence to which the exception applies. The amount can be rolled over if not used within 120 days if there is a delay or cancellation of the purchase or construction of the residence.

It’s a family affair for some exceptions

The penalty exceptions extend to certain family members in some cases. In other cases, only the participant qualifies. For example, exceptions due to disability, domestic abuse, and terminal illness apply only if the participant is disabled, suffered domestic abuse, or is terminally ill.

On the other hand, some expenses that trigger penalty-free distributions can cover family members. Examples include unreimbursed medical expenses, the qualified first-time homebuyer exception, and the higher education expenses exception.

The coverage varies depending on the type of distribution.

For instance, the first-time home buyer exception covers:

• the IRA owner’s spouse (each spouse gets their own $10,000 lifetime limit), the IRA owner or their spouse’s child,
• the IRA owner or their spouse’s grandchild, and
• the IRA owner or their spouse’s parent or another ancestor.

For unreimbursed medical expenses, qualifying individuals are:

• the IRA owner or plan participant (participant) and their spouse,
• all dependents they claim on their tax return,
• any child they do not claim as a dependent because of the rules for children of divorced or separated parents,
• any person who could have been claimed as a dependent on their return except that person received gross income amount that disqualifies them from being claimed as a dependent unless they or file a joint return, and
• any person who could have been claimed as a dependent except that they or their spouse, if filing jointly, can be claimed as a dependent on someone else’s return for the year.

Smart strategy: A taxpayer should have their CPA check whether family members are covered under an exception, and if so, which family members. The objective is to ensure that an exception is not claimed when it is not available.

Timing is important

The timing of a distribution can affect eligibility for the penalty exception. For example, a distribution for higher education expenses is determined on a taxable year basis, which means that the amount qualifies only if it is distributed in the same year that the expenses are incurred. On the other hand, a distribution due to disability applies only if it is made on or after the date the individual is certified as disabled—the same is true for exceptions for distributions due to terminal illness.

Smart strategy: Verifying eligibility is essential. For example, for the disability exception, an individual qualifies if they are unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of long continued and indefinite duration. The IRS might ask for proof of the disability. A taxpayer is not considered disabled for this purpose if the disability is temporary, even if totally incapacitated on a temporary basis.

A pre-distribution assessment is necessary

Some taxpayers only become aware of the 10% early distribution penalty when their tax return is being filed, leading to unpleasant surprises. Financial advisors can play a key role in helping clients avoid this “sticker shock” by ensuring they are informed of the additional tax and the rules that apply to exceptions. This role includes ensuring they are aware of any time limits or dollar limits that apply and whether the exception covers only the account owner or extends to a qualifying family member.