Tax Penalties on Early Retirement Plan Distributions

Retirement planning, of course, is a significant financial and timely commitment, as many individuals may need to amass hundred of thousands, if not, millions of dollars, to last through their golden years. To meet these ends, legions of Americans have opted to put money to work within IRA, 457, 403(b), and 401(k) retirement plans.

Retirement plans typically allow for pre-tax deductions and tax-deferred growth. These benefits, however, do come with a caveat of severe penalties for early withdrawals. All savers should take note of these restrictions, before early retirement plan withdrawal penalties wreak complete havoc upon carefully planned budgets.

Retirement Plan Structure

The U.S. government has structured various retirement accounts to encourage savers to set money aside over the long term, in preparation for retirement. Again, IRA, 457, 403(b), and 401(k) retirement plans effectively allow for tax-deductible contributions. After funding these accounts, savers may purchase stocks, bonds, and mutual funds that may grow upon a tax-deferred basis.

As such, investors will not owe taxes on capital gains, dividends, and interest income, as they occur within the account. Upon retirement, however, pre-tax retirement plan withdrawals will be taxed as ordinary income. For most, ordinary income tax rates will be higher than those upon capital gains.

Additional Tax Penalty

Early retirement plan distributions will be subject to both ordinary income taxes and an additional tax penalty. The severe additional tax penalty on early retirement account distributions has been legislated to discourage savers from feverishly yanking balances out of these accounts, before returns have been able to compound over the long term. The IRS has defined retirement plan distributions taken before age 59 ½ as early withdrawals, which are also typically subject to 10% additional tax penalties.

Immediately prior to tax season, brokerages will mail out 1099 forms to all clients that have taken these early retirement plan distributions. The 1099 will indicate the amount of the gross distribution in Box 1. Box 7 will also likely be completed with Distribution Code 1, when the additional tax penalty is in effect. From here, filers will complete IRS forms 1040 and 5329 to calculate their total respective tax liabilities.

Exemptions

Certain filers may be exempt from the 10% additional tax upon the early retirement plan distributions, if those withdrawals were allocated towards and triggered by untimely disability, medical expenses, health insurance premiums, and college tuition payments. Be advised further that the IRS strictly enforces its own guidelines and definition for each exemption.

Unreimbursed medical expenses must account for more than 7.5 percent of adjusted gross income to avoid the 10 percent penalty tax. The IRS also defines disability as a mental or physical condition that bars a worker from being gainfully employed within any profession.

Investment Strategy

A comprehensive financial plan will likely include retirement accounts alongside taxable brokerage and checking accounts. The liquidity will help savers avoid taking early retirement plan distributions.