If you have lost your job or suffered an economic emergency, you may be tempted or forced to make a withdrawal from your retirement account. Often my clients will come to me in the spring to prepare their taxes and I find they did not fully understand or were misinformed of the tax consequences of such a withdrawal.
The most problematic situation occurs when my client thinks they owe not additional tax because taxes were withheld from the distribution. That is not always the case. Your fiduciary probably withheld a flat rate of 10% or 20% depending on the amount of the distribution. However, if you are in a 28% tax bracket and you don’t meet one of the exceptions, you could also owe a 10% penalty for a total of 38% federal tax.
Another problem is that clients sometimes think they can but the money back into a retirement account. They can if they do it within 60 days of the distribution and they have to put the full distribution not the net amount they received. You can get the tax withheld back when you file your tax return.
10% Penalty from Early Distributions from a Retirement Plan
If you withdraw money from a qualified retirement plan, you may be subject to an additional tax of 10%. This is penalty for taking an early distribution from an individual retirement account (IRA), 401(k), 403(b), or other qualified retirement plan before reaching age 59 1/2. There are exceptions to this 10% penalty. A little known fact is this penalty may apply to Roth IRAs, even if it has been at least five years since you first opened up your Roth account. For Roth IRA account holders, it will be crucially important to review the exceptions to the 10% penalty, as otherwise the Roth distribution could become subject to both tax and the 10% penalty.
Here’s what you need to know about the early distributions and their tax consequences.
The additional tax on an early distribution is 10% of the taxable amount. The taxable amount is also included in your taxable income. This 10% tax is in addition to regular income taxes. I call this the early withdrawal tax penalty, because it is similar to the penalty banks charge when you liquidate a savings account early. You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income. So you will want to consider the tax impact before you tap your retirement accounts for short-term financial emergencies.
If you withdraw money from a SIMPLE IRA and you first began participating in a SIMPLE IRA plan within the past two years, then your early distribution penalty is 25% instead of 10%.
Reporting the Early Distribution Penalty
You figure the additional tax either directly on Form 1040 or on Form 5329, depending on your particular tax situation. Please refer to the Instructions for Form 5329 for all the details. Generally, you calculate the additional tax penalty directly on Form 5329 if you meet one of the exceptions and the retirement plan did not report the exception on Form 1099-R box 7.
Exceptions to the Early Distribution Penalties
You do not have to pay the additional 10% tax penalty on your early retirement distribution if you qualify for certain exceptions. There are two sets of exceptions. The first set below applies to individual retirement accounts (both traditional and Roth IRAs). The second set of exceptions applies to 401(k) and 403(b) retirement plans.
Exceptions for Early Distributions from an IRA:
- You had a “direct rollover” to your new retirement account,
- You received a lump-sum payment but rolled over the money to a qualified retirement account within 60 days,
- You were permanently or totally disabled,
- You were unemployed and paid for health insurance premiums,
- You paid for college expenses for yourself or a dependent,
- You bought a house*,
- You paid for medical expenses exceeding 7.5% of your adjusted gross income**, or
- The IRS levied your retirement account to pay off tax debts.
Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan:
- Distributions upon the death or disability of the plan participant.
- You were age 55 or over and you retired or left your job.
- You received the distribution as part of “substantially equal payments” over your lifetime.
- You paid for medical expenses exceeding 7.5% of your adjusted gross income.**
- The distributions were required by a divorce decree or separation agreement (“qualified domestic relations court order”),
* The home-buying exception has the following additional criteria: you did not own a home in the previous two-years, and only $10,0000 of the retirement distribution qualifies to avoid the tax penalty.
** You do not need to itemize in order to claim the medical expense exception.
If the exception is properly coded in box 7 of your 1099-R form, you do not need to fill out Form 5329. If an exception applies and is not recorded in box 7, then you need to fill out Form 5329.
1099-R Box 7 Distribution Codes
The following is a list of distribution codes that may appear in box 7 for Form 1099-R to report distributions from a retirement account. This list is taken from Instructions for Forms 1099-R & 5498.
Distribution Codes for 1099-R Box 7
| Guide to Distribution Codes | ||
|---|---|---|
| Distribution Codes | Explanations | *Used with code …(if applicable) |
| 1—Early distribution, no known exception. | Use Code 1 only if the employee/taxpayer has not reached age 59½, and you do not know if any of the exceptions under Distribution Code 2, 3, or 4 apply. Use Code 1 even if the distribution is made for medical expenses, health insurance premiums, qualified higher education expenses, a first-time home purchase, or a qualified reservist distribution under section 72(t)(2)(B), (D), (E), (F), or (G). Code 1 must also be used even if a taxpayer is 59½ or older and he or she modifies a series of substantially equal periodic payments under section 72(q), (t), or (v) prior to the end of the 5-year period. | 8, B, D, L, or P |
| 2—Early distribution, exception applies. | Use Code 2 only if the employee/taxpayer has not reached age 59½ and you know the distribution is:
|
8, B, D, or P |
| 3—Disability. | For these purposes, see section 72(m)(7). | None |
| 4—Death. | Use Code 4 regardless of the age of the employee/taxpayer to indicate payment to a decedent’s beneficiary, including an estate or trust. Also use it for death benefit payments made by an employer but not made as part of a pension, profit-sharing, or retirement plan. | 8, A, B, D, G, H, L, or P |
| 5—Prohibited transaction. | Use Code 5 if there was a prohibited transaction involving the account. Code 5 means the account is no longer an IRA. | None |
| 6—Section 1035 exchange. | Use Code 6 to indicate the tax-free exchange of life insurance, annuity, long-term care insurance, or endowment contracts under section 1035. | W |
| 7—Normal distribution. | Use Code 7: (a) for a normal distribution from a plan, including a traditional IRA, section 401(k), or section 403(b) plan, if the employee/taxpayer is at least age 59½, (b) for a Roth IRA conversion if the participant is at least age 59½, and (c) to report a distribution from a life insurance, annuity, or endowment contract and for reporting income from a failed life insurance contract under sections 7702(g) and (h). See Rev. Proc. 2008-42, available at www.irs.gov/irb/2008-29_IRB/ar19.html. Use Code 7 with Code A, if applicable. Generally, use Code 7 if no other code applies. Do not use Code 7 for a Roth IRA. Note: Code 1 must be used even if a taxpayer is 59½ or older and he or she modifies a series of substantially equal periodic payments under section 72(q), (t), or (v) prior to the end of the 5-year period. |
A |
| 8—Excess contributions plus earnings/excess deferrals (and/or earnings) taxable in 2010. | Use Code 8 for an IRA distribution under section 408(d)(4), unless Code P applies. Also use this code for corrective distributions of excess deferrals, excess contributions, and excess aggregate contributions, unless Code D or P applies. See Corrective Distributions on page 5 and IRA Revocation or Account Closure on page 3 for more information. | 1, 2, 4, B, or J |
| 9—Cost of current life insurance protection. | Use Code 9 to report premiums paid by a trustee or custodian for current life or other insurance protection. See box 2a on page 8 for more information. | None |
| A—May be eligible for 10-year tax option. | Use Code A only for participants born before January 2, 1936, or their beneficiaries to indicate the distribution may be eligible for the 10-year tax option method of computing the tax on lump-sum distributions (on Form 4972, Tax on Lump-Sum Distributions). To determine whether the distribution may be eligible for the tax option, you need not consider whether the recipient used this method (or capital gain treatment) in the past. | 4 or 7 |
| B—Designated Roth account distribution. | Use Code B for a distribution from a designated Roth account that is not a qualified distribution. But use Code E for a section 415 distribution under EPCRS. | 1, 2, 4, 8, D, G, L, P, or U |
| D—Excess contributions plus earnings/excess deferrals taxable in 2008. | See the explanation for Code 8. Generally, do not use Code D for an IRA distribution under section 408(d)(4) or 408(d)(5). | 1, 2, 4, or B |
| E—Distributions under Employee Plans Compliance Resolution System (EPCRS). | See Distributions under Employee Plans Compliance Resolutions System (EPCRS) on page 6. | None |
| F—Charitable gift annuity. | See Charitable gift annuities on page 9. | None |
| G—Direct rollover and rollover contribution. | Use Code G for a direct rollover from a qualified plan (including a governmental section 457(b) plan) or section 403(b) plan to an eligible retirement plan (another qualified plan, a section 403(b) plan, or an IRA). See Direct Rollovers on page 3. Also use Code G for IRA rollover contributions to an accepting employer plan. Note: Do not use Code G for a direct rollover from a designated Roth account to a Roth IRA. Use Code H. |
4 or B |
| H—Direct rollover of a designated Roth account distribution to a Roth IRA. | Use Code H for a direct rollover of a distribution from a designated Roth account to a Roth IRA. | 4 |
| J—Early distribution from a Roth IRA. | Use Code J for a distribution from a Roth IRA when Code Q or Code T does not apply. But use Code 2 for an IRS levy and Code 5 for a prohibited transaction. | 8 or P |
| L—Loans treated as deemed distributions under section 72(p). | Do not use Code L to report a loan offset. See Loans Treated as Distributions on page 6. | 1, 4, or B |
| N—Recharacterized IRA contribution made for 2010. | Use Code N for a recharacterization of an IRA contribution made for 2010 and recharacterized in 2010 to another type of IRA by a trustee-to-trustee transfer or with the same trustee. | None |
| P—Excess contributions plus earnings/excess deferrals taxable in 2009. | See the explanation for Code 8. The IRS suggests that anyone using Code P for the refund of an IRA contribution under section 408(d)(4), including excess Roth IRA contributions, advise payees, at the time the distribution is made, that the earnings are taxable in the year in which the contributions were made. | 1, 2, 4, B, or J |
| Q—Qualified distribution from a Roth IRA. | Use Code Q for a distribution from a Roth IRA if you know that the participant meets the 5-year holding period and:
Note:If any other code, such as 8 or P, applies, use Code J. |
None |
| R—Recharacterized IRA contribution made for 2009. | Use Code R for a recharacterization of an IRA contribution made for 2009 and recharacterized in 2010 to another type of IRA by a trustee-to-trustee transfer or with the same trustee. | None |
| S—Early distribution from a SIMPLE IRA in the first 2 years, no known exception. | Use Code S only if the distribution is from a SIMPLE IRA in the first 2 years, the employee/taxpayer has not reached age 59½, and none of the exceptions under section 72(t) are known to apply when the distribution is made. The 2-year period begins on the day contributions are first deposited in the individual’s SIMPLE IRA. Do not use Code S if Code 3 or 4 applies. | None |
| T—Roth IRA distribution, exception applies. | Use Code T for a distribution from a Roth IRA if you do not know if the 5-year holding period has been met but:
Note: If any other code, such as 8 or P, applies, use Code J. |
None |
| U—Dividends distributed from an ESOP under section 404(k). | Use Code U for a distribution of dividends from an employee stock ownership plan (ESOP) under section 404(k). These are not eligible rollover distributions. Note. Do not report dividends paid by the corporation directly to plan participants or their beneficiaries. Continue to report those dividends on Form 1099-DIV. | B |
| W—Charges or payments for purchasing qualified long-term care insurance contracts under combined arrangements. | Use Code W for charges or payments, for purchasing qualified long-term care insurance contracts under combined arrangements, which are excludible under section 72(e)(11) against the cash value of an annuity contract or the cash surrender value of a life insurance contract. | 6 |
| *See the first Caution for box 7 instructions on page 11. | ||
You calculate the additional tax on early withdrawals from a retirement account using Form 5329 lines 1 through 4.
Line 1: Report the taxable distribution from box 2a of Form 1099-R.
Line 2: Enter the amount not subject to the additional tax because an exception applies. Enter the appropriate exception code.
Line 3: Subtract line 2 from line 1. This is the amount of retirement distributions that are subject to the additional tax.
Line 4: Multiply the figure on line 3 by 0.10. Also enter this amount on Form 1040 line 60. If the distribution was from a SIMPLE IRA, the penalty may be 25% instead of 10%. The 25% penalty applies if you began participating in a SIMPLE IRA account within the past two years. Multiply the amount on Line 3 by 0.25 instead.
Exception Codes for Form 5329 Line 2
The following exception codes are to be used for Form 5329 Line 2 to inform the IRS that part or all of your retirement withdrawal is not subject to the early withdrawal tax penalty. The following exception codes are found in Instructions for Form 5329.
- 01 Qualified retirement plan distributions (does not apply to IRAs) if you separated from service in or after the year you reach age 55 (age 50 for qualified public safety employees).
- 02 Distributions made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from an employer plan, payments must begin after separation from service).
- 03 Distributions due to total and permanent disability.
- 04 Distributions due to death (does not apply to modified endowment contracts).
- 05 Qualified retirement plan distributions up to (1) the amount you paid for unreimbursed medical expenses during the year minus (2) 7.5% of your adjusted gross income for the year.
- 06 Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs).
- 07 IRA distributions made to unemployedindividuals for health insurance premiums.
- 08 IRA distributions made for higher education expenses.
- 09 IRA distributions made for purchase of a first home, up to $10,000.
- 10 Distributions due to an IRS levy on the qualified retirement plan.
- 11 Qualified distributions to reservists while serving on active duty for at least 180 days.
- 12 Other (see Other, below). Also, enter this code if more than one exception applies.
