Premature Distribution Rule

Taxable distributions you receive from your IRA or retirement plan before you reach the age of 59½ are generally considered by the IRS as premature distributions (or early withdrawals). To discourage these premature distributions, they are not only subject to the usual federal and state income taxes on distributions but also to a 10% federal penalty tax under Internal Revenue Code Section 72(t) (and possibly a state penalty tax). This 10% penalty tax is commonly referred to as the "premature distribution tax." Fortunately, not all distributions before age 59½ are subject to this penalty. The IRS does allow some exceptions (see below).

You may be wondering why your age at the time of a distribution should have a tax consequence and, in some cases, be subject to a penalty. The reason is that the underlying purpose of IRAs and retirement plans is to provide income to help fund your retirement years and the federal government wants to make sure you use the money for that purpose. To accomplish this goal, the government generally imposes a penalty on taxable distributions taken before age 59½. The penalty encourages you (and other IRA owners and plan participants) to leave your money in the IRA or plan until that age or later. This, in turn, reduces the risk that you will run out of money during your retirement. The assumption is that by the time you reach age 59½, you are either already retired or near retirement and can safely begin to use your retirement money.

Unless you meet one of the exceptions described below, you will generally be subject to the 10% federal penalty if you take a taxable distribution from one of the following prior to reaching age 59½:

• IRAs
• Qualified employer-sponsored retirement plans, including qualified stock bonus plans, pension plans, profit-sharing plans, and 401(k) plans
• Section 403(b) plans (tax-sheltered annuity plans for employees of public schools and certain tax-exempt organizations)

Tip: Distributions from 457(b) plans are usually not subject to the 10% penalty tax. However, if you roll over a distribution from an employer-sponsored retirement plan, 403(b) plan, or IRA to a 457(b) plan, those funds (and allocable earnings) will be subject to the 10% penalty when distributed from the 457(b) plan.

Generally, a premature distribution of after-tax or nondeductible contributions is not subject to the premature distribution tax. Although Roth IRAs have unique income tax benefits, "nonqualified distributions" from a Roth IRA are generally subject to the premature distribution tax only to the extent the distribution consists of earnings. However, if you convert a traditional IRA to a Roth IRA, or you roll over non-Roth funds from an employer retirement plan [such as a 401(k)] to a Roth IRA, and then you receive a premature nonqualified distribution of those converted amounts from the Roth IRA within five years of the conversion or rollover, the 10% premature distribution tax will apply to the entire amount of the distribution (to the extent that the distribution consists of funds that were taxed at the time of conversion). Each conversion or rollover is subject to a new five-year period for this purpose.

Caution: In some cases, a loan from an employer-sponsored retirement plan is considered a taxable distribution and may be subject to the 10% federal penalty.

Caution: Premature distributions from SIMPLE IRA plans are generally subject to a 25% federal penalty (rather than 10%) if taken within two years of beginning participation in the plan.

Tip: The 10% penalty tax does not apply to qualified distributions received as a result of certain natural disasters.

Income taxes on IRA and retirement plan distributions can really add up. And when a distribution is also subject to the 10% premature distribution penalty, the size of a distribution that goes into your pocket dwindles even further. To illustrate the possible effect of taking a distribution before age 59½, consider the following scenario.

Example(s): Joe retired on his 54th birthday, and on that day, he took a lump-sum distribution from his retirement plan valued at $100,000 after 15 years of participation in the plan. Because Joe had considerable other income from working that year, all of this distribution was taxed in the maximum 37% federal income tax bracket. That came to $37,000 in federal income tax (assuming no other variables). Joe was in a high-income-tax state — about 13% — so that meant another $13,000 in state income tax. Since Joe was under age 59½ and no exception to the premature distribution tax applied to him, he had to pay $10,000 in federal penalties (the 10% federal penalty), plus another $2,500 in state penalties (due to a 2.5% state penalty). He ended up paying $62,500 in taxes and penalties, leaving only $37,500 for his own use. That's 62.5% in taxes on his $100,000 distribution.

Example(s): If Joe had waited until he was 59½ or older to take his distribution (or delayed his separation from service until the year he reached age 55 — see exceptions below), he might have avoided the federal and state penalties and saved $12,500. Also, if he had waited two months until the next year (when he had no taxable income from working), the distribution might have been taxed in a much lower income tax bracket. It would definitely have paid for Joe to get tax advice before taking the lump-sum distribution from his retirement plan.

Example(s): Of course, if Joe had ever made any after-tax contributions to his retirement plan, the portion of his distribution that represented after-tax contributions would not have been taxable because those contributions had already been subject to tax. That portion of his distribution would not have been subject to the 10% federal penalty either, since the penalty applies only to the taxable portion of a premature distribution.

In general, try to avoid premature distributions to minimize the portion of your retirement funds that goes to the federal and state governments. If you are close to age 59½ and wish to take a distribution from your IRA or retirement plan, check the calendar carefully to avoid a potentially costly mistake.

There are certain exceptions to the 10% federal penalty on premature distributions. Distributions taken from an IRA or retirement plan under the following circumstances will generally not be subject to the 10% federal penalty, even if you are under age 59½ at the time of the distribution.

Distributions made to your beneficiary after your death

If you (the IRA owner or retirement plan participant) die, distributions made to a designated beneficiary are not subject to the penalty, regardless of the beneficiary's age or your age at the time of your death.

Distributions made due to your qualifying disability

To qualify for this exception, your condition must meet the IRS definition of a qualifying disability. This means that you must be unable to engage in any "substantial gainful activity" by reason of a "medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration." Consult a tax advisor for further details.

Distributions that qualify as a "series of substantially equal periodic payments"

Such payments must be made at least annually over your life expectancy, or over the joint life expectancy of you and a beneficiary. There are three IRS-approved methods for determining annual payments that qualify as "substantially equal." If you begin such a series of payments, you generally may not modify the payments for five years or until you reach age 59½, whichever is later. Otherwise, you will be subject to the 10% federal penalty on all payments made to you before age 59½.

Caution: Distributions from a qualified retirement plan do not qualify for this exception unless the periodic payments begin after you have separated from service with the employer maintaining the plan.

Tip: Thanks to a 2002 IRS ruling, taxpayers who take substantially equal payments (including those currently receiving such payments) are now permitted to make a one-time switch from the annuity or amortization method to the life expectancy method — without incurring the premature distribution tax.

Distributions made from a qualified plan (but not an IRA) after separating from service at 55 or older

To qualify for this exception, you must take the distribution from a qualified retirement plan [or 403(b) plan] after you have separated from service with the employer maintaining the plan, and your separation must occur during or after the calendar year in which you reach age 55. This exception does not apply to distributions made from an IRA. Also, if you roll over funds from the qualified plan to an IRA, this exception no longer applies to distributions made from the IRA.

Tip: This exception also applies to "qualified public safety employees" who separate from service after age 50, rather than age 55, and receive a distribution from a plan established by the federal government or its agencies, or by any state (or its political subdivisions or agencies). A qualified public safety employee is: (a) an employee of a state or political subdivision of a state who provides police, firefighting, or emergency services within the jurisdiction of the state or political subdivision, or (b) a federal law enforcement officer, customs or border protection officer, firefighter, or air traffic controller.

Certain distributions from an ESOP plan

Unless you are participating in an employee stock ownership plan (ESOP), this exception will not matter to you. If you are participating in such a plan, premature distributions that represent dividends paid with respect to the employer's corporate stock may not be subject to the 10% federal penalty. Consult your plan administrator or a tax advisor regarding this exception.

Distributions up to the amount of your tax-deductible medical expenses

If you have unreimbursed medical expenses, IRA or plan distributions up to the total amount of your allowable medical expense deduction are not subject to the 10% federal penalty. Your allowable medical expense deduction represents unreimbursed deductible medical expenses exceeding 7.5% of your adjusted gross income (AGI). It is not necessary to itemize deductions for this exception to apply, nor do the distributed funds have to be used to pay the unreimbursed medical expenses.

Distributions made from an IRA (but not a retirement plan) while unemployed (to the extent that the distributions do not exceed the amount you paid for health insurance premiums)

For this exception to apply, you must have separated from employment and must have received unemployment compensation for 12 consecutive weeks by reason of this separation. The health insurance premiums must be for you, your spouse, or your dependents. There is no requirement that the funds actually be used to pay the insurance premiums. This exception does not apply if the distribution is made after you are again employed for at least 60 days.

Tip: If you are self-employed, you may qualify for this exception if you would have received unemployment compensation "but for the fact that you are self-employed" (e.g., you were a sole proprietor but are now out of business).

Distributions made under a qualified domestic relations order

A qualified domestic relations order (QDRO) is a court order or judgment that gives someone (e.g., a spouse, former spouse, child, or other dependent) a right to receive benefits from another individual's qualified retirement plan or tax-sheltered annuity. This usually occurs in the context of a property settlement during a divorce. If a premature distribution is made pursuant to a QDRO, the distribution is not subject to the 10% federal penalty.

Nontaxable rollovers and transfers

Since the 10% federal penalty applies only to taxable distributions, tax-free rollovers of retirement assets are not subject to the penalty. A tax-free rollover is one that follows all federal rules with respect to rollovers. For example, the rollover generally must be completed within 60 days. Similarly, any transfer or distribution of assets from an IRA or retirement plan that is not considered a taxable distribution is not subject to the penalty (e.g., distributions to correct excess contributions).

Distributions made from an IRA (but not a retirement plan) to pay qualified higher education expenses

The 10% federal penalty does not apply to IRA distributions if the funds are used to pay "qualified higher education expenses." Such expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance; room and board if the individual is at least a half-time student; and expenses incurred by a special needs student in connection with his or her enrollment or attendance. The expenses must relate to the "postsecondary" (i.e., undergraduate or graduate) education of you, your spouse, or the child or grandchild of you or your spouse. This exception is not available when another exception applies. In addition, your qualified higher education expenses must be reduced by certain scholarships and benefits.

Distributions from an IRA (but not a retirement plan) to pay first-time homebuyer expenses

The funds must be used within 120 days to pay the costs of acquiring, constructing, or reconstructing the principal residence of a first-time homebuyer (this can be you or your spouse, or the child, grandchild, or ancestor of either you or your spouse). You are considered a first-time homebuyer if you did not own or have an ownership interest in another principal residence during the two-year period ending on the day that you buy your new home. This exception is subject to a $10,000 lifetime limit, and is not available when another exception applies.

Distributions in case of birth of child or adoption

The distribution can generally be made from any IRA or employer retirement plan (other than a defined benefit plan). The aggregate amount of qualified birth or adoption distributions with respect to any birth or adoption is limited to $5,000.

Amounts levied from IRAs and qualified plans by IRS

The 10% federal penalty does not apply to amounts that the IRS levies from your IRA or qualified plan to cover your federal income tax liability. This exception only applies if the IRS, in fact, attaches the IRA or qualified plan account. If you withdraw funds from your IRA or qualified plan before age 59½ to pay the IRS, that distribution would be subject to the 10% federal penalty (unless one of the other exceptions applies).

Qualified Reservist Distributions

The 10% federal penalty does not apply to "qualified reservist distributions." A qualified reservist distribution is a distribution:

1. From an IRA or attributable to elective deferrals under a 401(k) plan, 403(b) annuity, or similar arrangement,
2. Made to an individual who (by reason of being a member of a reserve component as defined in section 101 of title 37 of the U.S. Code) was ordered or called to active duty after September 11, 2001, for a period in excess of 179 days or for an indefinite period, and
3. That's made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period.

The 10% federal penalty on premature distributions is reported and paid on your federal income tax return for the year in which you received the distribution. You must complete and attach Form 5329, "Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts." If you receive a premature distribution but qualify for one of the exceptions described above, see Form 5329 for instructions.