Early Distributions From Retirement Plans

An early distribution from an Individual Retirement Arrangement (IRA) or a qualified retirement plan need not be a “taxing” experience. Fortunately, there are exceptions to early distributions.

Any payment that you receive from your IRA or qualified retirement account before you reach the age of 59½ is normally called an early or premature distribution.  As such, these types of funds are subject to an additional 10 percent tax, referred as the tax penalty for early distribution of retirement funds or early distribution penalty tax.  However, there are a number of exceptions to the age 59½ rule you may want to investigate if you happen to make such a withdrawal.  Some of these exceptions apply only to IRAs, some only to qualified retirement plans, and others to both.  IRS Publications 575, Pensions and Annuities, and 590, Individual Retirement Arrangements (IRAs), contain the details. 

In addition to the 10% penalty tax on early distributions, you are going to add to your regular taxable income any distributions attributable to “elective deferrals” which you contributed from your pay, your employer's contribution and any income earned on all contributions to the retirement account.  If you made any nondeductible IRA contributions, their portion of the distribution is not taxed, given that you’ve already paid tax on this amount. 

There exists a way to avoid paying taxes on early distributions, however.  It is known as an IRA rollover.  Usually, a rollover is a tax free transfer of cash or other assets from an IRA or qualified retirement plan to an eligible retirement plan.  An eligible retirement plan is a traditional IRA, a qualified retirement plan, or a qualified annuity plan.  You must complete the rollover within 60 days from the date you received the distribution.  The amount you roll over is generally taxed once the new plan pays you or your beneficiary. 

In the event that the early distribution from an employer's plan is paid directly to you, your plan administrator will normally withhold income tax at a rate of 20%.  If you roll over the distribution to a new plan, you must substitute that 20 percent of the funds that were withheld and deposit that amount in the new plan or you will owe taxes on that amount.  To avoid the hassle of this withholding, you can have your old plans' administrator transfer the rollover amount right to the new plan or a traditional IRA. 

All the early distributions must be reported to the IRS.  You are going to report tax free rollovers on lines 15a and 16a of Form 1040 along with any taxable distributions, but on lines 15b or 16b you will only enter the taxable amounts you will not roll over. 

Early distributions from retirement plans could certainly involve complex tax issues.  This is why you have to make sure you understand the issues or get competent tax advice.