What Happens When You Withdraw Retirement Funds Early?

Early withdrawals from retirement plans may be taxed twice

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You must generally include the money as taxable income on your tax return whenever you withdraw retirement funds early from your IRA, 401(k), or other retirement savings plan. The withdrawal might also be subject to an additional penalty tax—as much as 25% under some circumstances. The penalty kicks in when you take a distribution before reaching a certain age, usually 59½, although there are numerous exceptions to this rule.

The Penalty Tax

The penalty tax is normally 10% of the taxable amount you take an early distribution from an individual retirement account (IRA), a 401(k), a 403(b), or another qualified retirement plan before reaching age 59½.

The taxable amount must also be included in your taxable income, so you'll pay ordinary income tax on the distribution amount as well. Taxes are normally withheld from distributions, but if you're also subject to a penalty, this withholding might not be sufficient to cover all you owe.

The penalty increases to 25% if you take the distribution from a SIMPLE IRA within two years of the date you first began participating in the plan.

Exceptions to the Rules: IRAs

The exceptions for early distributions from IRAs include the following circumstances: 

  • You had a "direct rollover" to your new retirement account by way of a trustee-to-trustee transfer.
  • You received a payment, but you rolled the money over into another qualified retirement account within 60 days.
  • You were permanently or totally disabled at the time you took the withdrawal.
  • You were unemployed and used the money to pay for health insurance premiums.
  • You paid for college expenses for yourself, a dependent, or a grandchild.
  • You received the distribution as part of "substantially equal periodic payments" over your lifetime.
  • You paid for medical expenses exceeding 10% of your adjusted gross income (AGI) and you're under age 65.
  • The IRS levied your retirement account to pay off tax debts.
  • You're a qualified first-time homebuyer and you took distributions of up to $10,000. This doubles to $20,000, or $10,000 each, if you're married and purchase a first-time home together.
  • The distribution represents a return of nondeductible contributions.
  • It was a non-qualified distribution from a Roth IRA.

You cannot have owned a home in the previous two years to qualify for the homebuying exclusion, and only $10,000 of the retirement distribution will avoid the penalty. You'd be hit with the penalty on the $5,000 balance if you took $15,000.

Exceptions to the Rules: 401(k)s or 403(b)s 

Exceptions for early distributions from qualified retirement plans include the following circumstances: 

  • Distributions were made upon the death or total and permanent disability of the plan participant.
  • You were age 55 or older and you retired or left your job.
  • You were age 50 or older and you retired or left your job as a public safety employee of a state government.
  • You received the distribution as part of "substantially equal periodic payments" over your lifetime, but only if you've stopped working for your employer.
  • You paid for medical expenses exceeding 7.5% of your adjusted gross income.
  • The distributions were required by a divorce decree or separation agreement under the terms of a "qualified domestic relations court order." 
  • You received distributions of dividends from an employee stock ownership plan.
  • They were recovery assistance distributions.
  • They were qualified reservist or disaster distributions.
  • They were distributions from federal plans under a phased retirement program.
  • They were permissive withdrawals from a plan with automatic enrollment features.
  • They were corrective distributions and/or earnings associated with excess contributions.

Nontaxable Withdrawals

You generally won't get hit with a penalty if you take a distribution on which no tax is due. In other words, your contribution represents principal only and you paid tax on those dollars before you invested them.

The bottom line is that you did not take a tax deduction for your contributions, nor did your employer divert funds to your plan before calculating taxes on your pay.

Rollovers are also nontaxable, which is why they don't incur a penalty.

The Age 50 Rule

Certain government employees can access their retirement savings starting at age 50 rather than waiting until age 55 if they retire or leave their jobs early. These employees include nuclear materials couriers, United States Capitol Police, Supreme Court Police, and diplomatic security special agents. This rule applies to distributions from governmental retirement plans for employees who separate from service after reaching 50 years of age.

This change was made in 2015 as part of the Defending Public Safety Employees' Retirement Act of 2015.

Reporting the Early Distribution Penalty

You can figure the additional tax directly on your Form 1040, or you can use Form 5329. Your best option depends on your particular tax situation.

Generally, you would calculate the additional penalty on Form 5329 if you qualify for one of the exceptions and your retirement plan did not report the exception in box 7 of Form 1099-R. You don't have to fill out Form 5329 if the exception is properly coded in box 7 of your 1099-R form.

Report the tax on Schedule 2, which must accompany your tax return in tax years 2018 or later.

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