Hardship Distribution Rules for a Self-Directed IRA

There is usually no limit or restrictions on when a Self-Directed IRA owner may take a distribution from his or her IRA, although there may be adverse tax consequences. However, pursuant to Internal Revenue Code Section 72(t), there are certain instances where the IRS allows certain distributions that qualify as “hardship” distributions to be exempt from the additional tax on early distributions. In the following, we will explain the hardship distribution rules.

Early Distributions

The IRS seeks to discourage the use of IRAs distributions for purposes other than retirement.  As a result, an IRA holder will be assessed an additional 10% tax on early distributions from most retirement plans, unless an exception applies.

Generally, early distributions are those received from an IRA before reaching age 59 ½. This tax applies to the part of the distribution that would have to be included in gross income. It’s in addition to any regular income tax on that amount.

However, IRA funds that are directly rolled over or transferred to another IRA or qualified retirement plan are not subject to any tax. The same would apply to an indirect rollover, in which the IRA holder has sixty (60) days to re-contribute those funds to another retirement account. Note: an indirect rollover can only be done once every twelve months.

Hardship Distribution Rules

• The IRS, under certain circumstances, provides several exceptions to the additional 10% tax on early IRA distributions.  The thinking behind these exceptions is that there are certain personal situations that require some leniency.  Below is a summary of satisfying the exceptions to the early distribution penalty:

• The IRA holder is over the age of 59 ½.

• An IRA distribution made to a beneficiary or estate on account of the IRA owner’s death.

• An IRA distribution made on account of disability.

• Substantial equal periodic payments: An IRA distribution made as part of a series of substantially equal periodic payments for the IRA holder’s life (or life expectancy) or the joint lives (or joint life expectancies) of the IRA holder and his/her designated beneficiary pursuant to IRC 72(t). One must use an IRS-approved distribution method and must take at least one distribution annually for this exception to apply.

• An IRA distribution for a “qualified first-time home buyer.” Qualified first-time home buyer IRA distributions cannot be more than $10,000. To qualify for treatment as a first-time home buyer distribution, the distribution must meet certain requirements.

• An IRA distribution for qualified higher education costs. The part not subject to the early distribution tax is generally the amount that is not more than the qualified higher education expenses for the year for education furnished at an eligible educational institution.

• Health Insurance Premiums. An IRA distribution not in excess of certain medical insurance premiums paid while unemployed. The 10% early IRA distribution tax will not apply if certain conditions are met.

• Unreimbursed Medical Expenses. Even if one is under the age of 59 ½, one does not have to pay the 10% additional tax on IRA distributions that are not more than:
  
  
  • The amount paid for unreimbursed medical expenses during the year of the distribution, minus 10% (or 7.5% if the IRA holder or his/her spouse was born before January 2, 1952) of the adjusted gross income for the year of the distribution. In general, one can only take into account unreimbursed medical expenses that one would be able to include in figuring a deduction for medical expenses on Schedule A (Form 1040). However, one does not have to itemize deductions to take advantage of this exception to the 10% additional tax
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• An IRA distribution due to an IRS levy.

• An IRA distribution for a qualified reservist.

Conclusion

The exceptions to the 10% early distribution tax outlined above are intended to help IRA holders who find themselves in certain specific situations which require the need to access IRA funds to do so without having to pay an additional tax penalty. In other words, income tax would still be due on the pretax IRA distribution, however, the early distribution penalty would be waived under the specific exceptions set forth above and pursuant to IRC 72(t).

However, the reason that these exceptions are so limited, is that the IRS is attempting to encourage IRA holders to continue to save and grow their retirement funds and take advantage of the inherent tax saving benefits of tax deferral.  Anyone considering taking a hardship distribution with their IRA funds, should consult a tax advisor.