Many people have a substantial amount of money socked away in one or more retirement accounts, including IRAs (individual retirement accounts) and 401(k) plans through their employers. Such accounts provide tremendous tax benefits--contributions to most of them are deductible and the money in such accounts accrues tax-free until it is withdrawn upon retirement. However, you’re not supposed to withdraw money from these accounts until you reach age fifty-nine-and-one-half. This is intended to discourage people from using the money in these accounts for purposes other than normal retirement expenses. If you make an early withdrawal, you must pay regular income tax on the amount you take out plus a 10% penalty tax-ouch!
Fortunately, there are some exceptions to the early withdrawal penalty. You won’t have to pay the additional 10% tax penalty on an early withdrawal if you qualify for one of these exceptions. There are two sets of exceptions. The first set below applies to individual retirement accounts (both traditional and Roth IRAs). The second set of exceptions applies to 401(k) and 403(b) retirement plans.
Exceptions for Early Withdrawal from traditional IRAs
Early withdrawals from a traditional or Roth IRA are not subject to the 10% penalty tax if:
- you had a "direct rollover" to a new retirement account,
- you received a lump-sum payment but rolled over the money to a qualified retirement account within 60 days
- you are permanently and totally disabled
- you are unemployed and receive unemployment compensation for at least 12 weeks and use the withdrawals to pay for health insurance premiums
- you use the money to pay for college expenses for yourself or a dependent,
- you withdraw up to $10,000 to buy or build a first home
- you used to money to pay for medical expenses exceeding 7.5% of your adjusted gross income, or
- the IRS levied on your retirement account to pay off tax debts.
There are special rules for Roth IRAs because you do not obtain a tax deduction for the money you put into a Roth IRA. Instead, you pay no income tax on your withdrawals after age fifty-nine and one-half provided that you had the Roth IRA for at least five years. However you’ll have to pay regular income tax on early withdrawals unless they are made due to death, disability. or to purchase a first home. This is so even though the withdrawals are penalty-free because one of the exceptions discussed above applies.
Exceptions for Early Distributions from Plans Other than IRAs:
Early distributions from tax qualified retirement plans other than IRAs, including 401(k) plans and 403(b) plans are not subject to a 10% penalty if:
- you roll over the distribution to another retirement plan
- the plan participant died
- you are totally and permanently disabled
- You were age 55 or over and you retired or left your job
- You received the distribution as part of "substantially equal payments" over your lifetime
- You used the money to pay for medical expenses exceeding 7.5% of your adjusted gross income
- The distributions were required by a divorce decree or separation agreement ("qualified domestic relations court order"), or
- The IRS levied on your retirement account to pay off tax debts.
Legal Help for Tax Penalties
A tax attorney can help you sort out what you might owe in penalties and taxes due to an early withdrawal of retirement funds. An attorney can also help you successfully claim an exception to the 10% tax penalty and comply with IRS reporting requirements. Some exceptions may be reported on the IRS1099-R form, while others are reported on the usual 1040 form.