Using Retirement Money for Medical Bills: What the 10% Exception Covers

A serious diagnosis comes with two kinds of bills. The first kind comes from the hospital. The second kind comes from the IRS, about a year later, when you file the return for the year you emptied your IRA to pay the first kind.

The tax code does give people in a medical crisis some relief. It is narrower than most people think, and it is easy to lose by doing things in the wrong order. Here is how it works.

Two different taxes, two different questions

Every early retirement withdrawal raises two separate questions:

1. Is the withdrawal included in income? For a traditional IRA or 401(k), the answer is almost always yes. The money went in before tax, so it comes out taxable.
2. Does the 10% additional tax apply? IRC Section 72(t)(1) adds 10% of the taxable amount for early distributions, generally those before age 59 and a half. The medical exceptions answer only this second question.

Here is the part most people miss. Qualifying for a medical exception does not make the withdrawal tax free. It removes the 10% add-on. You still owe ordinary income tax on the distribution. If you forget that, you will plan for the wrong number.

Exception one: medical expenses above the 7.5% floor

Section 72(t)(2)(B) exempts distributions to the extent they do not exceed the amount you could deduct for medical care under Section 213 for the same year, "determined without regard to whether the employee itemizes deductions."

That last phrase is important. You get this exception even if you take the standard deduction. But the measurement is still the Section 213 formula. IRS Tax Topic 502 explains that medical and dental expenses count only "to the extent these expenses exceed 7.5% of your adjusted gross income for the year," and only for expenses "not compensated by insurance or otherwise."

Walk through an example. Say your adjusted gross income for the year is $80,000, including the retirement withdrawal. Seven and a half percent of that is $6,000. If you paid $20,000 of unreimbursed medical expenses in the same year, the excess is $14,000. Up to $14,000 of early distributions that year may escape the 10% additional tax. Anything above that may not.

Notice the trap. The withdrawal itself raises your adjusted gross income, which raises the 7.5% floor, which shrinks the exception. Bigger withdrawals protect a smaller share of themselves. For a fuller explanation of what counts as a medical expense, see the medical expense deduction rules.

Timing matters

The statute ties the exception to medical expenses "paid during the taxable year." A withdrawal in December to cover bills you pay in January of the next year does not line up. Pay the bills in the same calendar year you take the distribution, and keep the receipts.

Exception two: terminal illness

Section 72(t)(2)(L) exempts distributions made to an employee who is a terminally ill individual, on or after the date a physician certifies the terminal illness. For this purpose the statute borrows the definition from Section 101(g)(4)(A) but substitutes 84 months for 24 months. The Form 5329 instructions describe it as an illness expected to result in death within 84 months.

The documentation requirement is real. The statute says the employee must furnish sufficient evidence to the plan administrator in the form and manner the IRS requires. Get the physician certification before the distribution, not after. Section 72(t)(2)(L)(iv) also allows these distributions to be repaid under rules similar to the birth or adoption repayment rules, which can matter if the prognosis changes.

Exception three: health insurance premiums after job loss

Medical crises often cost people their jobs. Section 72(t)(2)(D) exempts IRA distributions used to pay health insurance premiums for you, your spouse and dependents after you lose your job, if you received unemployment compensation for 12 consecutive weeks because of the separation. The distribution has to come in the year unemployment is paid or the following year, and the exception stops once you have been reemployed for at least 60 days.

This one applies to IRAs, not 401(k) plans. If your money is still in an employer plan, the order of operations matters. See cashing out a 401(k) after a layoff for the rollover issues.

Exception four: disability

If the medical crisis has left you unable to work, Section 72(t)(2)(A)(iii) may apply. It covers distributions attributable to being disabled within the meaning of Section 72(m)(7), which requires that you be unable to engage in any substantial gainful activity because of a medically determinable impairment expected to result in death or to be of long-continued and indefinite duration. That is a high bar, but when it is met, it is not capped by your medical bills. I cover it in detail in the disability exception to the early withdrawal tax.

Exception five: the small emergency distribution

Section 72(t)(2)(I) allows one emergency personal expense distribution per calendar year for "unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses." The cap is the lesser of $1,000 or the amount your vested balance exceeds $1,000. It is a small tool, but it may cover a deductible or a copay without the 10% hit.

Withholding: what comes out of the check

Withholding depends on the type of account and the type of distribution.

• 401(k) and other employer plans. If the distribution is an eligible rollover distribution, Section 3405(c) requires 20% withholding unless you elect a direct rollover. A hardship distribution is different. Section 402(c)(4)(C) excludes "any distribution which is made upon hardship of the employee" from the definition of an eligible rollover distribution, so the 20% mandatory rule does not apply to it. Whether your plan offers hardship distributions, and for what, depends on the plan document.
• IRAs and other nonperiodic distributions. Section 3405(b) requires 10% withholding on a nonperiodic distribution unless you elect out.

Withholding is not the same as your tax. In a year with large withdrawals, the amount withheld may fall short. If you elected out of withholding to get the full amount for medical bills, set money aside or make an estimated payment.

Reporting: make sure the exception is claimed

The plan reports the distribution on Form 1099-R. Plans usually do not know about your medical bills, so the box 7 code often says the distribution is early with no known exception. You claim the exception yourself on Form 5329. The Form 5329 instructions assign exception code 05 to distributions up to unreimbursed medical expenses above 7.5% of AGI, 07 to IRA distributions for health insurance premiums while unemployed, 03 to disability, 20 to terminal illness and 23 to emergency expense distributions.

Keep the medical bills, the proof of payment, the unemployment records and the physician certification with your tax file. If the IRS questions the exception, those documents are your case.

Better options to check first

• A health savings account. If you have one, qualified medical distributions from an HSA are generally tax free. See HSA withdrawals during a medical crisis.
• Roth contributions. Roth IRA contributions can generally be withdrawn under ordering rules before earnings, which may create less tax than a traditional IRA withdrawal. Confirm your basis before relying on this.
• Payment arrangements with the provider. Hospitals often agree to payment plans. A payment plan costs less than a taxable withdrawal plus a possible 10% additional tax.

The bottom line

Retirement money used for medical bills is still taxable income. The 10% additional tax can be avoided in specific situations: medical expenses above the 7.5% floor, terminal illness, premiums after a job loss, disability, and the small annual emergency distribution. Pay the bills in the same year, document everything, and claim the exception on Form 5329.

Your health comes first. Just do not let the treatment plan create a tax plan you never agreed to.