Retirement Related Penalty Taxes You Need to Be Aware Of

The government encourages everyone to save money for their retirement. Tax breaks such as the Retirement Savings Contribution Credit and penalties for early distributions from retirement plans exist for your own sake. The IRS charges a penalty of additional tax on most early withdrawals from retirement plans in order to prevent people from using their retirement savings for anything other than their income from retirement. Any money you take out of a qualified retirement before you reach the age of 59 ½ is an early distribution or early withdrawal in general. 

The following are types of qualified retirement plan:

• A Traditional IRA or a Roth IRA
• An employee plan including a 401(k)
• An employee annuity plan including a 403(a)
• A 403(b) or similar plan for public school employees and tax-exempt organizations

Qualified retirement plans generally don’t include state or local government 457 plans and early distributions from these are not subject to a penalty of penalties on federal taxes. If you make an early withdrawal from a qualified retirement plan, the amount is added to your gross income. As part of your gross income, you will owe tax on the distribution at your normal effective tax rate. A penalty of additional tax on the amount of the early withdrawal is owed by you if additional to normal income tax unless you met an exception.

Early Withdrawal Additional Tax Penalty

If you make an early withdrawal from a retirement plan, the tax penalty will be equal to 10% of the amount that your income has included. In addition to regular income tax, a penalty must be paid.

If you won’t be able to cover your taxes and the penalty because your tax withholdings and/or estimated tax payments aren’t enough, you will owe money when your return is filed.

The roll-over distributions you made to another qualified retirement plan are generally not taxable and are not subject to a 10% additional penalty of taxes. If you do a rollover from a non-Roth account towards a Roth account, it is considered as taxable income and not early distributions. 

Early Withdrawal Tax Penalty Exceptions

The 10% additional tax penalty has some exceptions. You still have to report your withdrawal as income even if you qualify for one of the exceptions. However, you will not be required to pay the 10% additional tax penalty.

Here are the following exceptions to the penalty that is applicable to early distributions from any qualified retirement plan, IRAs included:

• The distribution occurred to your estate or beneficiary after your death.
• The distribution occurred because you are permanently and totally disabled.
• The withdrawal occurred to cover qualified post-secondary expenses on education.
• The withdrawal occurred to cover medical expenses that are deductible.
• The distribution occurred for an IRS levy to be paid.
• The withdrawal was a Qualified Reservist Distribution, one made after being called to active duty for 180 days in general.
• The distribution occurred as an installment in a series of equal and periodic payments over your life expectancy or over you and your beneficiary or beneficiaries’ life expectancy. You must have left employment before payment began if the retirement plan is not an IRA.

For retirement plans that are Traditional or Roth IRAs, the following two exceptions apply:

• The distribution occurred in order for the medical insurance premiums of you, your spouse or a dependent to be paid while you were unemployed.
• The distribution occurred in order for you to buy a home for yourself, your spouse, or any of your parents, grandparents, children or grandchildren. You or they must be a qualifying first-time homebuyer.

For qualified retirement plans that are not traditional or Roth IRAs, the remaining exceptions below apply:

• The distribution was received after you resigned from working with your employer if during or after the year you turned age 55 you left employment.
• The distribution was made to an alternate beneficiary or payee as stated by a qualified domestic order.
• The distribution is composed of divides from a qualified employee stock ownership plan.