Feature Articles: Taxes
Early distributions from retirement plans
Reviewed and used with special permission from the IRS by: Brenda Procter, M.S., State Specialist & Instructor, Personal Financial Planning, University of Missouri Extension
An early distribution from an Individual Retirement Arrangement (IRA) or a qualified retirement plan need not be a “taxing” experience, according to the IRS.
Any payment that you receive from your IRA or qualified retirement
plan before you reach age 59½ is normally called an early or premature
distribution. As such, these funds are subject to an additional
10 percent tax. But there are a number of exceptions to the age
59½ rule that you should investigate if you make such a withdrawal.
Some of these exceptions apply only to IRAs, some only to qualified
retirement plans, and some to both. IRS Publications 575, Pensions
and Annuities, and 590, Individual Retirement Arrangements
(IRAs) have the details.
In addition to the 10 percent tax on early distributions, you
will add to your regular taxable income any distributions attributable
to “elective deferrals” that you contributed from your pay, your
employer's contribution and any income earned on all contributions
to the account. If you made any nondeductible contributions, that
portion of the distribution is not taxed, since you've already paid
tax on this amount.
There is a way to avoid paying any tax on early distributions,
however. It is called a rollover. Generally, a rollover is a tax-free
transfer of cash or other assets from an IRA or qualified retirement
plan to an eligible retirement plan. An eligible retirement plan
is a traditional IRA, a qualified retirement plan, or a qualified
annuity plan. You must complete the rollover within 60 days of when
you received the distribution. The amount you roll over is generally
taxed when the new plan pays you or your beneficiary.
If the early distribution from an employer's plan is paid directly
to you, your plan administrator will normally withhold income tax
at a 20 percent rate. If you roll over the distribution to a new
plan, you must replace that 20 percent of the funds that were withheld
and deposit that amount in the new plan, or you will owe taxes on
that amount. To avoid the inconvenience of this withholding, you
can have your old plan's administrator transfer the rollover amount
directly to the new plan or to a traditional IRA.
Early Distributions from SIMPLE IRAs
Two-year rule: To qualify as a tax-free rollover (or a tax-free trustee-to-trustee transfer), a rollover distribution (or a transfer) made from a SIMPLE IRA during the 2-year period beginning on the date on which an employee first participated in his or her employer's SIMPLE plan must be contributed (or transferred) to another SIMPLE IRA. The 2-year period begins on the first day on which contributions made by the employer are deposited in the employee’s SIMPLE IRA.
After the 2-year period, amounts in a SIMPLE IRA can be rolled over or transferred tax free to an IRA other than a SIMPLE IRA, or to a qualified plan, a tax-sheltered annuity plan (section 403(b) plan), or deferred compensation plan of a state or local government (section 457 plan).
Additional Tax on Early Distributions
The additional tax on early distributions (discussed above) applies to SIMPLE IRAs. If a distribution is an early distribution and occurs during the 2-year period following the date on which the employee first participated in his or her employer's SIMPLE IRA plan, the additional tax on early distributions is increased from 10% to 25%.
If a rollover distribution (or transfer) from a SIMPLE IRA does not satisfy the 2-year rule, and is otherwise an early distribution, the additional tax imposed because of the early distribution is increased from 10% to 25% of the amount distributed.
You can download Publications 575 and 590, along with any related forms and instructions, through Forms and Publications on the IRS website at www.irs.gov. You can also order the forms by calling toll free: 1-800-TAX-FORM (1-800-829-3676).
Source: IRS. (2011). Retirement topics: Tax on early distributions. Retrieved from http://www.irs.gov/retirement/participant/article/0,,id=211440,00.html
Last update: Wednesday, February 29, 2012