10% Penalty from Early Distributions from a Retirement PlanIf you withdraw money from a qualified retirement plan, you may be subject to an additional tax of 10%. This is penalty for taking an early distribution from an individual retirement account (IRA), 401(k), 403(b), or other qualified retirement plan before reaching age 59 1/2. There are exceptions to this 10% penalty. A little known fact is this penalty may apply to Roth IRAs, even if it has been at least five years since you first opened up your Roth account. For Roth IRA account holders, it will be crucially important to review the exceptions to the 10% penalty, as otherwise the Roth distribution could become subject to both tax and the 10% penalty.
Here's what you need to know about the early distributions and their tax consequences.
The additional tax on an early distribution is 10% of the taxable amount. The taxable amount is also included in your taxable income. This 10% tax is in addition to regular income taxes. I call this the early withdrawal tax penalty, because it is similar to the penalty banks charge when you liquidate a savings account early. You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income. So you will want to consider the tax impact before you tap your retirement accounts for short-term financial emergencies.
If you withdraw money from a SIMPLE IRA and you first began participating in a SIMPLE IRA plan within the past two years, then your early distribution penalty is 25% instead of 10%.
Reporting the Early Distribution PenaltyYou figure the additional tax either directly on Form 1040 or on Form 5329 (pdf), depending on your particular tax situation. Please refer to the Instructions for Form 5329 (pdf) for all the details. Generally, you calculate the additional tax penalty directly on Form 5329 if you meet one of the exceptions and the retirement plan did not report the exception on Form 1099-R box 7.
Exceptions to the Early Distribution PenaltiesYou do not have to pay the additional 10% tax penalty on your early retirement distribution if you qualify for certain 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 Distributions from an IRA:
- You had a "direct rollover" to your new retirement account,
- You received a lump-sum payment but rolled over the money to a qualified retirement account within 60 days,
- You were permanently or totally disabled,
- You were unemployed and paid for health insurance premiums,
- You paid for college expenses for yourself or a dependent,
- You bought a house*,
- You paid for medical expenses exceeding 7.5% of your adjusted gross income**, or
- The IRS levied your retirement account to pay off tax debts.
Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan:
- Distributions upon the death or disability of the plan participant.
- 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 paid 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"),
* The home-buying exception has the following additional criteria: you did not own a home in the previous two-years, and only $10,0000 of the retirement distribution qualifies to avoid the tax penalty.
** You do not need to itemize in order to claim the medical expense exception.
If the exception is properly coded in box 7 of your 1099-R form, you do not need to fill out Form 5329. If an exception applies and is not recorded in box 7, then you need to fill out Form 5329.
1099-R Box 7 Distribution CodesThe following is a list of distribution codes that may appear in box 7 for Form 1099-R to report distributions from a retirement account. This list is taken from Instructions for Forms 1099-R & 5498 (PDF).
Distribution Codes for 1099-R Box 7
|1||Early distribution, no known exception|
|2||Early distribution, exception applies|
|6||Section 1035 exchange|
|9||Cost of life insurance protection|
|A||May be eligible for 10-year tax option|
|E||Excess annual additions|
|F||Charitable gift annuity|
|J||Early distribution from Roth IRA|
|L||Loans treated as deemed distributions|
|N||Recharacterized IRA contribution|
|Q||Qualified distribution from a Roth IRA|
|R||Recharacterized IRA contribution|
|S||Early distribution from a SIMPLE IRA in the first two years, no known exception|
|T||Roth IRA distribution, exception applies|