When you take a taxable distribution from a 401k, pension, or IRA account, that taxable income is treated as ordinary income and is computed as part of your taxable income for the year. Not only do you pay income tax on the distribution but because it is included in your taxable income, it can push all your income into a higher tax bracket and increase the taxes you pay on all the rest of the earnings for the year. A non-taxable distribution from retirement accounts would include a rollover to another qualified account (such as another 401k or IRA) or a distribution of qualified Roth money.
In addition to the income tax, Congress has instituted Internal Revenue Code section 72(t) which is commonly known as the 10% penalty. It is meant to be a deterrent to keep people from taking early distributions from their retirement savings. In addition to the income tax, you will pay an extra 10% as a penalty. So for example, if you take a $10,000 distribution from your 401k after you leave the company and your tax rate is 25% for the year, you would owe $2,500 in income tax plus an additional $1,000 for the 10% penalty, so you would owe $3,500 to the IRS and leave you just $6,500.
Congress has carved out several exceptions to the penalty where it has determined the use of retirement funds – in its opinion – is deemed appropriate enough to avoid the penalty. The biggest exclusion from the penalty is taking distributions after 59.5 years old. Any distributions from your retirement accounts after this age do not incur the penalty. In addition to the age 59.5 cutoff, there are exceptions that allow people under the age of 59.5 to take early distributions without incurring the penalty:
- If you leave your job after you turn 55 you can take distributions at any time from an employer-sponsored retirement plan (not an IRA) without incurring the penalty. If you rollover that plan to an IRA the exception goes away, so if this exception applies to you then it may not make sense to rollover to an IRA until after you turn 59.5 if you foresee taking early distributions.
- You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
- If the distribution is from an IRA and the distribution is less than or equal to the cost of medical insurance.
- You have been deemed disabled (by Social Security Administration).
- You are the beneficiary of a deceased plan participant or IRA holder.
- If the distribution is from an IRA and the distribution is not more than qualified higher education expenses for the year.
- An IRA distribution of $10,000 or less to purchase the account holder’s first primary residence.
- The distribution is due to an IRS levy.
- The distribution is a qualified reservist distribution.
- The distribution is a timely distribution to reduce excess elective deferrals or excess contributions from either the employee or employer to a retirement plan.
- To an alternate payee under a qualified domestic relations order (QDRO).
- The distribution is dividends paid from an ESOP.
- The distribution is a permissive withdrawal of an elective automatic contribution arrangement (EACA). If your employer’s 401k plan automatically enrolls you and contributions are withheld from your paycheck although you did not want to participate in the plan, in certain circumstances some plans may allow you to take these automatic contributions back from the plan.
- The payments are taken as substantially equal periodic payments. This is a tricky exception that easily risks causing problems if the distributions are not set up appropriately. The entire account must be converted in substantially equal periodic payments so the entire account is distributed (or should be distributed) by the last expected periodic payment. These payments can be annuitized for the account owner’s remaining life expectancy and avoid the penalty, even if payments start before age 59.5. This requires implementing an appropriate annuitization calculation so that the payments should exhaust the account by the end of the account holder’s life. However, the payments can be for less than the entire life. Periodic payments must extend for the later of five years or age 59.5. These payments must also be properly calculated to exhaust the account with the last periodic payment (although based on investment profits or losses, it may not actually coincide). If you take payment at age 30, the payments must be calculated to extend until age 59.5 because it takes longer to reach 59.5 than five years; but if you start the periodic payments at age 57 the payments must be calculated to extend until 62, because the five year period is longer than reaching age 59.5.
If you are contemplating taking an early distribution and you believe an exception applies, you should speak with a qualified tax professional who can assess your individual situation and determine how the distribution will affect your taxes and if an exception would apply. The above information is not tax advice and should not be used to determine whether an exception applies. It is purely informational and does not contemplate your situation.