Early Distributions from Retirement Plans

The federal government encourages saving for retirement by way of deferring taxes on contributions to Individual Retirement Accounts (IRAs) and qualified retirement plans at your place of work. They attempt to discourage you from removing that money before your retirement age by imposing stiff penalties on early distributions, or withdrawals. Fortunately for us, there are exceptions for which early distributions are not taxed.

If you receive any payment, or distribution, from your IRA or qualified retirement plan before you reach the age of 59 1/2, that distribution is generally considered to be early, or premature. These distributions are subject to a penalty in the amount of an additional 10 percent tax. However, if you need to make such a withdrawal, be sure to consult the IRS for the rules and exceptions concerning retirement funds. Some exceptions pertain only to IRAs, others only apply to qualified retirement plans. Others, still, are valid for both.

In addition to the 10 percent tax that’s levied on early distributions, you’ll have to add to your regular taxable income any distributions made which were attributable to elective deferrals that were funded from your pay or from your employer’s contribution, as well as any income earned on all other contributions to the account. The portion of a distribution that’s from a non-deductible contribution is not taxed, since the contribution was made with after-tax dollars. All early distributions, whether taxable or non-taxable, must be reported to the IRS when filing your tax return.

If you want to avoid paying any tax on an early distribution, it can be accomplished by means of a rollover. Basically, a rollover is a transfer of cash or other assets from an IRA or qualified retirement plan to an eligible retirement plan. An eligible retirement plan can be a traditional IRA, a qualified retirement plan, or a qualified annuity plan. The amount that you roll over is generally taxed when you or your beneficiary begins receiving regular distributions.

There are two ways in which to accomplish the rollover. If the distribution from an employer’s plan is paid directly to you, the plan administrator will normally withhold income tax at a rate of 20 percent. When you deposit the distribution into a new plan, you must replace the amount that was withheld, or you will owe taxes on that amount. In other words, you’re still responsible for rolling over the full 100 percent of the amount that was in your plan before you withdrew it. You must complete the rollover within 60 days from the day that you received the distribution. To avoid the inconvenience of that withholding, you can direct your old plan’s administrator to transfer the rollover amount directly into your new plan. No money is withheld, and the rollover is completed tax-free.

Early distributions from retirement plans can involve complex tax issues. You can get further information from IRS Publications 575 Pensions and Annuities and 590 Individual Retirement Arrangements. For any questions, be sure to seek the help of a competent tax professional.