Additional Tax on Early Distributions from Retirement Plans:
Many commonplace retirement plans, such as the 401(k), offer significant incentives for people to save for retirement. Such incentives include tax deferrals and contribution matches. However, a 10 percent penalty applies to most early withdrawals. For the most part, this penalty applies to distributions taken from qualified retirement plans or deferred annuity contracts before the age of 59.5.
There are certain criteria that determine if the early withdrawal penalty is applicable and there are some exceptions that apply to these rules. First, it is important to define the term "qualified retirement plan" as generally, only these types of plans are subject to the penalty. In general, the following criteria apply:
- Employee plans under section 401(a), such as the common 401(k) plan, and employee annuity plans under section under section 403(a) are qualified retirement plans.
- Tax-sheltered annuity plans under section 403(b), which are typically applied to employees of public schools or tax-exempt organizations, are qualified.
- Individual section 408(a) retirement accounts, commonly known as the standard "IRA," or section 408(b) annuities are qualified.
- Government section 457 deferred compensation plans are not considered qualified and are not subject to the early withdrawal penalty. An exception to this rule is for funds that are attributable to transfers or rollovers from qualified plans.
In addition to the above, there are certain exceptions that apply even to qualified plans that do not require the 10 percent penalty. The following most common exceptions are distributions which are made:
- To the plan holder's beneficiary or estate after death.
- To the plan holder because he is permanently disabled.
- Under a series of "substantially equal period payments" which are to be made over the duration of the life expectancy of the plan holder or the combined life expectancies of the holder and his beneficiary.
- To pay for medical expenses if the expenses exceed 10 percent (or, until the end of 2016, 7.5 percent for individuals 65 years or older) of the plan holder's deductible income for that specific year.
- Due to an IRS levy under section 6231.
- As qualified reservist distributions, which are made of individuals called for active duty for at least 180 days, or
- As rollovers to another qualified retirement plan.
Lastly, the following additional exceptions apply only to qualified plans other than IRAs and are also not subject to the early withdrawal penalty. These are distributions which are:
- Made after the plan holder has left his employer if this event occurred not earlier than the age of 55.
- Made from a qualified governmental defined benefit plan of a qualified public safety employee, after the plan holder has left his employer if this event occurred not earlier than the age of 50.
- Made to an alternate recipient under a qualified domestic relations order.
- In the form of dividends from employee stock plans.
Those are have taken early withdrawals must report this on IRS Form 1040 when filing taxes for the year in which the withdrawal was made. Additionally, in some cases, IRS Form 5329 must also be filed. This applies in situations where:
The distribution is subject to tax and distribution code "1" is not shown in the appropriate box of Form 1099-R.
One of the aforementioned exceptions applies but the "Distribution Code(s)" box does not show the distribution code "2," "3" or "4."
Form 5329 need not be filed if the distribution is subject to the 10 percent penalty and distribution code "1" shows in the appropriate box. In this case, one only needs to enter the 10 percent penalty on the relevant line of Form 1040 and write "no" on the dotted line next to the appropriate line.
Finally, it is important to note that generally, all distributions from a qualified plan are subject to federal income tax withholding. However, if the distribution triggers the 10 percent penalty, the standard withholding may not be enough, and one may have to make additional estimated tax payments. More information can be found in IRS Publication 505.