Retirement Fund Early Withdrawals and the Tax Penalty

As a veteran tax preparer, I have found that there are lots of reasons why folks don't file returns. But one of the biggest reasons is the early withdrawal of retirement funds. Most of the time they don't elect to have federal tax withheld. Then when it comes time to file and that 1099-R arrives in the mail, fear overwhelms them. Now they're facing not only the federal withholding, but also the 10% penalty for early withdrawal.

Below is some detailed information which I found at William Perez's website at About.com which gives the best overview of early withdrawals that I have found on the web. Take a few minutes to see just how overwhelming these withdrawals can be to your tax liability.

If you withdraw money from a traditional individual retirement account (IRA), 401(k), 403(b), or other qualified retirement plan before you turn age 59 1/2, you may be subject to an early distribution penalty of 10%. There are exceptions. This penalty does not apply to Roth IRAs as long as it has been at least five years since you first opened up your Roth account. Here's what you need to know about the early distribution tax.

The additional tax on an early distribution is 10% of the taxable amount. The taxable amount is also included in your taxable income. This 10% tax is in addition to regular income taxes. I call this the early withdrawal tax penalty, because it is similar to the penalty banks charge when you liquidate a savings account early. You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income.

So you will want to consider the tax impact before you tap your retirement accounts for short-term financial emergencies.

If you withdrew money from a SIMPLE IRA and you first began participating in a SIMPLE IRA plan within the past two years, then your early distribution penalty is 25% instead of 10%. You figure the additional tax either directly on Form 1040 line 59, or on Form 5329 (PDF) and Instructions for Form 5329 (PDF). You calculate the additional tax penalty directly on Form 5329 if you meet one of the exceptions and the retirement plan did not report the exception on Form 1099-R box 7.

To calculate the additional tax penalty directly on Form 1040 line 59, you:

1. Look on Form 1099-R from your retirement plan.
2. Find the figure in boxes 1 (Gross Distribution) and 2a (Taxable Amount), and the code in box 7 (Distribution Codes).
3. Multiply the amount in box 2a by 0.10.
4. Report this amount on Form 1040 Line 60.
5. Write "No" on the dotted lines next to line 59 to inform the IRS that you do not need to attach Form 5329.

Exceptions to the Early Distribution Tax Penalties

You do not have to pay the additional 10% tax penalty on your early retirement distribution if you certain exceptions. Exceptions for Early Distributions from an IRA:

1. You had a "direct rollover" to your new retirement account,
2. You received a lump-sum payment but rolled over the money to a qualified
   retirement account within 60 days,
3. You were permanently or totally disabled,
4. You were unemployed and paid for health insurance premiums,
5. You paid for college expenses for yourself or a dependent,
6. You bought a house*,
7. You paid for medical expenses exceeding 7.5% of your adjusted gross income**, or
8. The IRS levied your retirement account to pay off tax debts.

Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan:

1. Distributions upon the death or disability of the plan participant.
2. You were age 55 or over and you retired or left your job.
3. You received the distribution as part of "substantially equal payments" over your
   lifetime.
4. You paid for medical expenses exceeding 7.5% of your adjusted gross income.**
5. The distributions were required by a divorce decree or separation agreement
   ("qualified domestic relations court order"),

* The home-buying exception has the following additional criteria: you did not own a home in the previous two-years, and only $10,0000 of the retirement distribution qualifies to avoid the tax penalty. ** You do not need to itemize in order to claim the medical expense exception. If the exception is properly coded in box 7 of your 1099-R form, you do not need to fill out Form 5329. If an exception applies and is not recorded in box 7, then you need to fill out Form 5329.

1099-R Box 7 Distribution Codes

The following is a list of distribution codes that may appear in box 7 for Form 1099-R to report distributions from a retirement account. This list is taken from (PDF), pages 9 and 10. Distribution Codes for 1099-R Box 7

Distribution Code	Description
1	Early distribution, no known exception
2	Early distribution, exception applies
3	Disability
4	Death
5	Prohibited transaction
6	Section 1035 exchange
7	Normal distribution
8	Excess contribution
9	Cost of life insurance protection
A	May be eligible for 10-year tax option
D	Excess contribution
E	Excess annual additions
F	Charitable gift annuity
G	Direct rollover
J	Early distribution from Roth IRA
L	Loans treated as deemed distributions
N	Recharacterized IRA contribution
P	Excess contribution
Q	Qualified distribution from a Roth IRA
R	Recharacterized IRA contribution
S	Early distribution from a SIMPLE IRA in the first two years, no known exception
T	Roth IRA distribution, exception applies

Figuring the Additional Tax Penalty on Form 5329

You calculate the additional tax on early withdrawals from a retirement account using Form 5329 (PDF) lines 1 through 4.

Line 1: Report the taxable distribution from box 2a of Form 1099-R.

Line 2: Enter the amount not subject to the additional tax because an exception applies. Enter the appropriate exception code.

Line 3: Subtract line 2 from line 1. This is the amount of retirement distributions that are subject to the additional tax.

Line 4: Multiply the figure on line 3 by 0.10. Also enter this amount on Form 1040 line 60. If the distribution was from a SIMPLE IRA, the penalty may be 25% instead of 10%. The 25% penalty applies if you began participating in a SIMPLE IRA account within the past two years. Multiply the amount on Line 3 by 0.25 instead.

Exception Codes for Form 5329 Line 2

The following exception codes are to be used for Form 5329 Line 2 to inform the IRS that part or all of your retirement withdrawal is not subject to the early withdrawal tax penalty. The following exception codes are found in Instructions for Form 5329 (PDF), pages 2 and 3.

01: Separation from service after reaching age 55.

02: Distributions are paid as part of a series of substantially equal periodic payments.

03: Distributions due to permanent and total disability.

04: Distributions due to death.

05: Distributions to pay for medical expenses exceeding 7.5% of adjusted gross income.

06: Distributions to another person under a qualified domestic relations court order.

07: Distributions to pay for health insurance premiums and you were unemployed.

08: Distributions to pay for college expenses.

09: Distributions to pay for a first-time home purchase, up to $10,000.

10: Distributions due to an IRS levy.

11: Other. Use this code if more than one exception applies and see IRS Instructions page 3.

S. Raines, Sr. Financial Advisor/Tax Preparer