By Jeremy T. Rodriguez, JD
To discourage early access to amounts invested in IRAs and company retirement plans, the IRS imposes a 10% early distribution penalty on withdrawals before age 59 ½. Even though Roth IRAs consist of after-tax contributions, the penalty could also apply to converted amounts or earnings. There are several exceptions to the 10% early distribution penalty, which means taxpayers should be familiar with these before electing a distribution. Doing so will help them possibly avoid this penalty.
Unfortunately, the exceptions do not apply uniformly to IRAs and company retirement plans; that would be too easy. Instead, some exceptions apply only to IRAs, others only to company plans, and still others to both! To make this process easier, we’ve created the chart below to track the application of the various 10% penalty exceptions. Use this chart when determining whether an IRA or company retirement plan distribution will trigger the penalty.
|Plans and IRAs (including SEP and SIMPLE IRAs)||IRAs Only (including SEP and SIMPLE IRAs)||Plans Only|
|Annuitizing (72(t) Payments)||x|
|Qualified Reservists Distributions||x|
|Roth IRA Conversions||x|
|Higher Education Expenses||x|
|First-Time Home Buyer||x|
|Health Insurance (if unemployed)||x|
|Age 55 (termination of employment)||x|
|Age 50 for Public Safety Employees (termination of employment)||x|
|Section 457(b) (governmental plans||x|
|Divorce (Qualified Domestic Relations Orders)||x|
|Phased Retirement Distributions from Federal Plans||x|
Keep in mind that these exceptions can be combined, so long as the applicable rules and restrictions are met. For example, let’s say a taxpayer has an IRA with a $250,000 account balance. For the 2019 taxable year, the taxpayer withdrawals $40,000 from his IRA. During that same year, the taxpayer’s daughter had $30,000 in higher education expenses and his spouse had $5,000 in medical expenses. If the taxpayer is under age 59 ½, only $5,000 of the withdrawal will be subject to the 10% early distribution penalty (i.e., $40,000 – $35,000 = $5,000).
However, all too often taxpayers misunderstand these rules and get hit with the 10% early distribution penalty. For example, many people with company retirement plans mistakenly believe that the higher education exception applies to their withdrawal (it doesn’t) or that a hardship distribution doesn’t trigger the 10% penalty (it does). Making matters worse is the absence of any relief for these types of mistakes under the Tax Code, plus the fact that courts rarely side with taxpayers on these issues. Therefore, it is vital that taxpayers fully understand these rules prior to taking distributions.