Early Retirement Plan Withdrawals and Your Taxes

Early Retirement Plan Withdrawals and Your Taxes

Early Retirement Plan Withdrawals and Your Taxes

Most of the time my advice is, DO NOT take money out of a retirement plan early, but I understand that SOMETIMES it’s a necessity, although when I say sometimes, I really basically mean net to never (A withdrawal is considered early if it’s taken before you reach the age of 59 and a half).

Here’s why:  Early withdrawals may require you to pay an additional 10% tax on the total amount withdrawn.  It’s technically a “tax”, but taxpayers like you and me usually call this “tax” the “early withdrawal penalty”. There is some good news, however – multiple exceptions to the rule exist.  If you are set on taking an early withdrawal, you should DEFINITELY take advantage of an exception if one applies. I’ve identified many of these exceptions below.  Make sure you consult with an expert before making a final determination so you don’t get the wrong kind of attention from the IRS (Isn't any type of attention from the IRS, the “wrong kind"?  Yea, I'd say so.). 

Some exceptions to the early withdrawal penalty are as follows:
·      Death of the Participant:  If you die, your beneficiaries are able required to take distributions from your IRA without penalty.

·      Total and Permanent Disability of the Participant/Owner:  If you are “totally and permanently disabled” as defined by the IRS, an early withdrawal will not be penalized.

·      Divorce:  The money taken from your account under a Qualified Domestic Relations Order within the divorce process is not subject to the tax penalty.  A QDRO does not apply to an IRA though.  For an IRA, the specifics of any split must be included in a final divorce judgment.

·      Roth IRA conversion:  You can convert funds from a traditional IRA to a Roth IRA without paying the 10% penalty.  Remember you will be taxed on the distribution though.

·      Series of Substantially Equal Payments:  If you receive withdrawals through a series of substantially equal periodic payments over your life expectancy, those payments won’t be subject to the additional tax.

·      Dividend Pass Through from an Employee Stock Ownership Plan:  An ESOP is a type of retirement plan that usually has similar features of a traditional pension plan but is funded with stock of your employer.  Distributions of dividends from employer stock held inside an ESOP are not subject to the early distribution tax.

·      Qualified First-Time Homebuyers:  Up to $10,000 (or $20,000 for a couple) of the costs of buying, building or remodeling a “first home” is not subject to the 10% tax.  The “first home” designation applies if you can show that you had no interest in a main home within 2 years before the “first home” was purchased.

·      Payment to an Adviser or Investment Manager:  You can to authorize your plan custodian to pay your investment manager from your IRA funds any fees for managing your IRA without having to pay the extra penalty.

·      IRS Levy:  The IRS can levy your retirement plan if you owe back taxes.  In the event that the IRS seizes the cash in your retirement plan, you don’t have to pay the early withdrawal penalty.  Make sure you don’t find yourself in this situation though.  Call Wolf Tax if you are concerned about an IRS levy.

·      Unreimbursed Medical Expenses:  You are allowed to pay a limited amount of medical expenses from your plan without incurring the penalty.  The formula for determining how much is determined by the IRS.

·      Medical Insurance Premiums while Unemployed:  If you've lost your job and get unemployment compensation, you are eligible to withdraw from your plan in order to pay for your medical insurance premiums without being penalized but there are restrictions.

·      Distributions to Military Reservists in Active Duty:  This exception includes making awithdrawal from your IRA during active-duty if you were called up after Sept. 11, 2001, and served for at least six months.

·      Periodic Temporary Relief Provisions:  Congress has historically enacted special legislation allowing people affected by natural disasters to withdraw money from their retirement plans without paying the 10% tax including victims of hurricanes and flooding. 

This is not a comprehensive list of the exceptions available to taxpayers, but it’s a great start.  The exceptions should be pretty simple, but as it always is when dealing with the IRS, the tax rules for retirement plans are complex.  Feel free to contact the experts at Wolf Tax if you intend on making an early withdrawal from your retirement account.  It is important to do it right the first time to make sure you don’t become a target for harassment by the IRS.