Occasionally, a taxpayer will pull their retirement funds in an effort to pay off debt and restructure their personal finances only to find, come April 15th, that 10% early withdrawal penalty does not begin to cover the taxes being assessed. This is particularly true for taxpayers in the 15 and 25% marginal tax brackets–that is, for taxpayers for whom each additional dollar of income is taxed at 15 or 25%.
The following general information is presented to give taxpayers a base from which to research and plan, if deemed necessary, for the possibility of having to make an early withdrawal from his or her retirement plan.
Notable Tax Law Facts
First and foremost, penalties on early withdrawals made to pay overdue taxes are only forgiven if the IRS actually pulls the funds with a tax lien. If the taxpayer does it of the taxpayer’s own volition, penalties will be assessed and prevail.
Second, those taxpayers no longer working for a company at which they participated in a 401(k) should be aware that if they can wait until the year they turn 55 (not reach age 55 but the year they turn 55) all the early withdrawal penalty is forgiven. Reiterating the three factors here: (1) 401(k)-type plans, (2) no longer working for the company, and (3) turning 55 in the year the withdrawal will be made. (For qualified public safety employees, the age marker is 50.)
Different Retirement Vehicles Have Different Exceptions
Most, but not all, distribution taken from a retirement plan prior to age 59 and 1/2 are considered early distributions or withdrawals. The early withdrawal penalty of 10% does not apply for certain uses of the withdrawn funds. These exceptions are different for 401(k)-type plans and IRA plans.
Taxpayers pulling a retirement 401(k) to pay tuition or purchase a first time home would be well-advised to roll have a trustee-to-trustee rollover from the 401(k) to an IRA before the tuition payment or down payment on a home become a reality. Once the 401(k) funds are transferred into an IRA, they lose the 401(k) exception attributes and gain the IRA exception attributes.
IRA early distributions may be exempt from the early withdrawal penalties if they are made:
- to unemployed individuals for health insurance premiums
- for higher education expenses
- for purchase of a first home, up to $10,000.
Taxpayers needing funds to supplement living expenses over a period of time might look into whether it is possible to take periodic payments, made at least annually, over their lives and live expectancies.
Disability and Death Exceptions
Early distributions due to total and permanent disability generally do not incur early withdrawal penalties. Distributions due to death are generally not penalized. The beneficiary, however, will pay taxes on the income that has not been taxed. They will need to either periodic payments or pull the entire amount within five years of the decedent’s death.
Other types of distribution exceptions and their applicability to a given taxpayer’s situation can be researched in the instructions to IRS Form 5329.
Jeannine Silkey - With over 40 years work experience, Jeannine Silkey has a wealth of practical information for the small business owner. Keeping it simple, ...
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