The Retirement Account Early Withdraw Penalty and Some Exceptions to Avoid It The two most common places where people keep their savings are in their IRA and 401k accounts. While most people realize that it is in their long term financial interest to not tap in to these accounts until retirement, sometimes they do not have a choice. So what happens if a short term financial struggle suddenly outweighs your long term financial goals? The answer is that the short term struggle will usually win out at the expense of your nest egg. But what happens to you from a tax perspective? The answer is--if you withdraw out of your retirement account early, the IRS imposes a 10% penalty on that distribution. They do this to discourage the use of retirement funds for purposes other than normal retirement, and because the fact that taxpayers invested pretax dollars in to a retirement account. In most cases, the contributions either came out of your paycheck before taxes were taken out, or you were given a deduction on your tax return for contributing to an IRA. The early distribution that you receive will also be considered income for the tax year, and subsequently taxed at your personal income tax rate. The IRS considers a distribution early when you withdraw it from a qualified retirement plan like a 401k or IRA before reaching the age of 59 ½, but just like every other area of tax, there are exceptions to this rule, and to complicate matters even further, the IRS has a different set of exceptions for both IRA and a 401k early withdraws. Taxpayers can avoid the ten percent penalty on withdraws from either plan under these circumstances; the distribution was made because the participant was disabled at the time of withdraw, or was made to you as a beneficiary because the participant passed away. The penalty can be removed if the distribution was to cover a debt due to an IRS levy, dispersed as part of a qualified annuity, or was dispersed to qualified reservists after age 55. These exceptions listed above will only remove the additional ten percent penalty, taxpayers will still have to include the total distribution as income for the tax year. There are a few exceptions to the early withdraw penalty for participants of IRA plans that do not apply to participants of 401k plans. These include distributions used to build or buy a first home, distributions used on qualified higher education expenses, and also the cost of medical insurance for those who are unemployed. Any amounts of the early distribution that are in excess of the exceptions mentioned above, will be subject to the ten percent penalty. For example, if a taxpayer withdrew 20,000 dollars from their IRA, but only had 15,000 dollars of college expenses, then the difference (5,000) will be subject to the ten percent tax. There are a few common exception issues that usually arise with participants of 401k accounts, as opposed to IRA participants, most notably loans against 401k’s, and distributions to reduce excess contributions. Generally, if a loan is permitted by the 401k plan, a participant may borrow up to 50% of the account balance, with a maximum of 50,000 dollars. The loan must be repaid within 5 years, unless the loan is used to buy the participant’s home. 401k loans do not have to be picked up as income, and are not subject to the ten percent penalty as long as they are paid back in the appropriate time frame. Also, 401k distributions taken to reduce excess contributions from you, or your employer, are not subject to the ten percent penalty, the maximum contribution for 2010 is 16,500 dollars. Avoiding the ten percent penalty can have a massive financial impact on you, and your family, going forward. If you believe that you have incorrectly paid a penalty on a distribution, you can amend a prior year return up to three years from the due date. You will need to file form 5329 for the appropriate tax year to recoup the additional tax from the IRS. |