Exceptions to Tax on Early Distributions

Exceptions to Tax on Early Distributions


This post was written by Woodside Wealth's Fall Intern Kevin Henderson.

The long wait to take distributions from your retirement plan(s) may end sooner than you think. If you are 59½ or younger, early distributions from your IRA, 401k or other qualified retirement plans could charge you an additional 10% tax, but there are many exceptions that may allow you to take your money out early with no additional tax.

For anyone older than 59½, tax-deferred 401k and traditional IRA plan distributions are recorded as income (gains) and are taxed at the individual’s tax bracket rate. For early withdrawals from any retirement account, one may be required to pay an additional 10% tax rate for any non-exempt withdrawal. The IRS has listed eighteen ways in which individuals can avoid this 10% tax.

Among the exceptions, IRAs and SEPs have the most leeway when compared to a 401k and other similar plans. Circumstances that provide exemption for all qualified plans include; the death of a participant/owner, a total or permanent disability of participant/owner, a series of substantially equal payments withdrawn, an unreimbursed medical expense above 10% of annual gross income and certain distributions to qualified military reservists called to active duty.

As previously mentioned, IRAs and SEPs have more circumstances that would prompt exemption from the 10% tax. These include: qualified higher education expenses, up to $10,000 for qualified first-time homebuyers, health insurance premiums paid while unemployed and if one’s returned IRA contributions are withdrawn by the extended due date of return.

Some 401k and other associated plans are more restrictive in receiving the tax break. Exemptions for 401k and similar plans include: corrective distributions of excess contributions, a dividend pass through from an ESOP, or if the employee separates from service during of after the year the employee reaches age 55 (age 50 for some public safety employees).

Check out the full list of circumstances that could exempt you from the 10% early distributions tax here: https://www.kiplinger.com/members/links/ktl/180907/72t_Chart.pdf

We do not necessarily suggest that our clients take out distributions early, but it may be beneficial to some families and their specific financial situations. Withdrawing from these accounts early, will greatly impact the future value of your plan. Consider this situation: You are 45 years old and you want to withdraw $10,000 to cover an immediate expense. If it is exempt, then you can simply take out the full amount, but if the amount is not exempt, you will need to withdraw $11,000 to cover the 10% tax. With $10,000 withdrawn and assuming the average year over year return for the account has been 7% and you plan to retire at 65, your future account value will decrease by $41,405.

If you would like help planning for your retirement savings, consider reaching out to us at https://www.woodsidewealth.com/contact.

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