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taxes

Taxes

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Tax Penalty for Early Withdrawal of Retirement Funds

 

If you lose your job or, if money is tight, some people will look to take money from their retirement account as a way to make ends meet. This can seem like a good idea in the short run, but you should be aware of the tax consequences of withdrawing retirement funds early. In addition to the income taxes you will owe on any of the money you withdraw, you may also have to pay an additional 10% penalty for taking out the funds before you retire.

There are tax penalties for taking early distributions (money invested plus interest earned on that money) from your retirement plan. In general, if you take the money before you turn 59½, there is a 10% penalty on the amount that you take out. Also, generally you must pay taxes on money taken from an Individual Retirement Account (IRA), a 401(k), or another retirement plan. Money taken from those plans must be included as part of your taxable income in the year you take the money out. To do this, you must file a Form 5329 along with your tax return. If you do not properly report the distribution and pay the tax that is due on it, the IRS may contact you about the tax debt and you will be liable for interest and penalties.

Following is more information about the tax problems caused by taking early distributions.

Tax/penalties

The additional tax/penalty on an early distribution is 10% of the taxable amount. This 10% is in addition to regular income taxes. If the distribution is from a simple IRA and you began to participate in the simple IRA plan within the past two years, the tax/penalty is even greater (25% of the taxable amount).

Exceptions to the penalties

There are some situations where there are exceptions to the 10% penalty. The first list of exceptions below applies only to two kinds of IRAs (simple IRAs and Roth IRAs). The second list applies to 401(d) and 403(b) retirement plans. All of the exceptions listed below are subject to specific rules and regulations. To claim an exception, you must report the exception on the Form 5329 that you file with your tax return.

There are no taxes or penalties on early distributions from simple IRAs and Roth IRAs when:

  • You directly rolled the money over (transferred the money) to a new retirement account.
  • You received a lump-sum payment and rolled it over to a qualified retirement account within 60 days.
  • You are permanently or totally disabled.
  • You are unemployed, receiving unemployment compensation, and you used the distribution for health insurance premiums.
  • You used the distribution for college expenses for yourself or your dependents.
  • You used the distribution to purchase a home, as long as you did not own a home within the past two years. (Only $10,000 of retirement funds qualify for the exception.)
  • You used the distribution for medical expenses that exceeded 7.5% of your adjusted gross income.
  • The IRS took the money from (levied) the retirement account to pay off tax debts.

There are no taxes or penalties on early distributions from qualified retirement plans, such as 401(k) and 403(b) plans, when:

  • You received the distribution because the person who participated in the plan became disabled or died.
  • You were over the age of 55 and had retired or lost your job when you took the distribution.
  • You received the distribution as part of substantially equal payments over your lifetime.
  • You used the distribution for medical expenses that exceeded 7.5% of your adjusted gross income.
  • The distributions were required by a court as a part of a divorce/separation judgment or agreement.

Special information about taking early distributions due to disability

People commonly take early distributions from their retirement plans because they become disabled. In order to be considered disabled, you need to prove that:

  • You were not able to work in the year of the distribution at a job that requires activities a lot like the activities of your previous jobs.
  • Your disability is expected to be permanent (last for a long time or forever) or it is expected to result in your death. It is also better if the disability was considered to be permanent at the time of the distribution.

It is best to show that the disability will last a long time or is permanent

The IRS seems to be more concerned with how long the disability is expected to last rather than how serious it is. The IRS has denied disability exceptions for chemical dependence and chronic depression, even when the taxpayers were hospitalized for those conditions.

Save doctors' reports and medical records

If you have taken or plan on taking an early distribution of your retirement funds because you have become permanently disabled, remember to save all doctors’ reports and medical records. You will have to prove to the IRS that you are entitled to the disability exception. However, you should remember that you still owe taxes on a part of the distribution as income in the year that you received it. Often, the IRS takes several years to challenge any items you reported on your return or to contact you regarding additional taxes that it believes you owe.

This article is from the May 2010 issue of Looking Out for Your Legal Rights®.

This information last reviewed 11/2/11.

 

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