Retirement & Eldercare

Avoiding the Pitfalls of Early Retirement Distribution Penalties

Delia Mena
Avoiding the Pitfalls of Early Retirement Distribution Penalties

Trying to save money for retirement can be challenging, which is why there are many different tools and vehicles for retirement savings. Your retirement funds are designed to go into these plans so that the funds will grow over time and also so that you can't access them right away. If you treat your retirement plan like a savings account to tap into for car payments or taking a lavish vacation, you will get penalized for doing so.

However, life often gets in the way and you may need to tap into your 401(k), IRA or other qualified plan in an emergency if you have no other choice. Here's what you need to know about early withdrawal of retirement plan funds and what you can do to abate penalties on early distributions.

What is an Early Distribution?

Early distributions are distributions taken from tax-deferred plans like 401(k)s and traditional IRAs before you reach retirement age. While "retirement age" has become a nebulous term in recent years with a record amount of seniors still working after age 65, generally for tax purposes you are considered to be taking an earlier distribution if you are younger than 59 1/2 years old at the time of the distribution.

If you are under 59 1/2 and your distribution does not fit into any of the eligible categories for penalty abatement, you are subject to a 10% early distribution penalty on top of whatever federal and state income taxes you will owe on the distribution. In some cases you may even be subject to a state early withdrawal penalty. So if you take out just $5,000 from your 401(k) because you want to start a business, in addition to taxes on that $5,000 you are also responsible for paying a $500 penalty if you are under 59 1/2 and do not meet any of the following conditions.

Eligible Expenses and Conditions for Penalty Abatement

  • First-time homebuyer up to $10,000: If you are a first-time homebuyer and you need to gather the funds to buy your primary residence, you can take a distribution of up to $10,000. If you are married, both you and your spouse can take $10,000 from your respective IRAs. However, this is only true of IRAs. You would need to roll over the funds from any qualified plans like a 401(k) into an IRA first.
  • Higher education expenses: Similarly to the first-time homebuyer exception, only IRA owners are eligible for this benefit. There is no dollar limit on how much money can be withdrawn penalty-fee for you, your spouse, or dependent to go to school, however the distribution is taxable. Still, there are a number tax-advantaged ways to pay for college that may allow you to avoid tapping your retirement funds. In addition, most student loans have a lower cost than taking a premature retirement plan distribution and the interest may be tax deductible.
  • IRS levies: If you have unpaid taxes to the point that the IRS has put a levy on your property, you can have a penalty-free distribution from  your retirement account if you can get the IRS to levy the account. Caution: This only applies if the IRS actually levies your retirement account.
  • Certain amounts of medical expenses: If you have large medical bills, you may be able to get a penalty abatement on amounts withdrawn to pay unreimbursed medical expenses that would be deductible on Schedule A during the year and that exceed 10% (7.5% through 2016 for taxpayers age 65 or older) of the taxpayer's AGI. This is true even if the taxpayer does not itemize. If you are an IRA owner and you lose your job, you can take penalty-free distributions to pay for health insurance while you are unemployed.
  • Separation from service the year you turn 55 or the year after (age 50 for certain public employees): This applies only to qualified plan owners if you are laid off or quit when you turn 55 (or 50 for certain public employees on state defined-benefit pension plans.) Most people roll over their funds to an IRA or a new job's plan but if you turned 55, or 50, you can take distributions without penalty if you separated from service that year.
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Delia Mena

Delia Mena

Delia Mena, CPA is a Tampa based tax professional who specializes in accounting and tax preparation. Delia is the founder of her own tax based practice, Delia's Accounting Service, based in Tampa, FL. With over 12 years of experience, Delia's practice is fully equipped to assist clients with any of their financial needs. Delia's Accounting Service provides the perfect mix of independent paralegal's, bookkeepers, and notary public professionals providing high quality services to a wide range of clients. To learn more about Delia and her practice, visit her website.

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