Facts About Taking Early Distributions from Retirement Plans

When times are tough, taxpayers will sometimes look to their retirement plans as a quick source of needed cash.  If you are contemplating or have taken an early distribution from your retirement plan, here are some things you need to know:

1.  Payments that are received from an Individual Retirement Arrangement before the taxpayer reaches age 59½ are generally considered early or premature distributions.

2.  In addition to the tax due on the distribution amount, early distributions are usually subject to an additional 10% tax.  For example, you have a financial emergency and need to withdraw from a retirement account.  You are in the 25% federal tax bracket and 6% state tax bracket.  Your combined tax on the distribution will be 41% (25% 6% 10%).  That is a hefty price to pay for a quick source of cash; so you are cautioned to tap your retirement funds only when you have no other alternatives.

3.  There are exceptions that will permit you to avoid the 10% penalty in very special circumstances.  Some exceptions apply to all types of plans, while others apply to IRAs only or qualified plans other than an IRA.  They include exceptions for buying your first home, paying medical insurance while unemployed, paying higher education expenses, disability, payment of medical expenses, etc.  Please call this office to see if there is an exception for your actual or contemplated withdrawal.  But keep in mind that even though the penalty might be waived by one of the available exceptions, the distribution will still be taxable and there are no exceptions for that. 

4.  If you only need the funds for a short period of time, you can avoid the tax and 10% penalty by rolling the distribution into another IRA or qualified retirement plan.  But to avoid the tax, you must complete the rollover within 60 days after receiving the distribution. You may roll over a distribution from one IRA to another only once in any 12-month period.

5.  In some circumstances, as specified below, part of the distribution might be tax-free. 

• If you made nondeductible contributions to an IRA and later take distributions from that same IRA, the portion of the distribution attributable to those contributions is not taxed, and for an early distribution the 10% penalty will not apply to the nontaxable portion.

• If you received an early distribution from a Roth IRA, the distribution attributable to contributions is not taxed. 

If the distribution is from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.

If you are contemplating a distribution, it might be appropriate to contact this office in advance to see if there are any actions or alternatives that might be employed to minimize the taxes and penalties on the distribution.

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