Early Distributions from Retirement Plans

Are you subject to a penalty?

When money gets tight, it can be tempting to tap into a retirement account. While it can seem like an easy, painless way to pay off some bills, it can be very expensive come tax time. A quick fix can become a painful burden.

If you take any money from a “qualified retirement plan” (an IRS-approved plan set up by an employer) before you turn 59 1/2, it is an early distribution. Early distributions are generally taxable AND subject to an additional 10% penalty. For example, a person in the 25% tax bracket who takes a $5,000 early distribution from his 401(k) plan could have to pay $1,250 in federal income tax plus $500 for the penalty, as well as perhaps $340 in New York state income tax.

There are some specific exceptions to the penalty (but not the tax).  You may be able to avoid the additional 10% for some or all of any distributions that are:

•                    Due to death.

•                    Due to the account owner's disability.

•                    Withdrawn in substantially equal periodic payments.

•                    Due to separation from service after age 55 (employer-provided plans only).

•                    Equal to medical expenses exceeding 7.5 % of adjusted gross income.

•                    On account of an IRS levy.

•                    Under a qualified domestic relations order (employer-provided plans only).

Note that hardship is not one of the exceptions. Although some employer plans allow “hardship withdrawals”, such withdrawals are still subject to both tax and the 10% penalty (unless some other exception applies).

Some additional exceptions only apply to early distributions from an IRA, including:

•                    Health insurance related distributions when you are unemployed.

•                    A portion of distributions taken for qualified higher education expenses.

•                    A portion of distributions taken for first-time home purchases.

It is important to know which exceptions apply to which types of plans. If you take an early distribution from an IRA to pay qualified higher education expenses, the 10% penalty does not apply. However, if you take an early distribution from a 401(k) for the same purpose, the penalty does apply. (In that case, you may be able avoid the penalty if you roll over the distribution from the 401(k) into an IRA first and then take a distribution from the IRA.)

It's always best to seek the advice of a tax professional before taking ANY distribution from ANY retirement plan. If you have questions, please feel free to contact our tax professionals.

(June 14, 2010)

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